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Executives

Eileen B. Askew – Manager of Investor Relations

Mark C. Valdon – Executive Chairman

Diane Irvine – Chief Executive Officer

Marc D. Stolzman – Chief Financial Officer

Analysts

Doug Anmuth – Barclays Capital

Mark Mahaney – Citigroup

Herman Leung – Deutsche Bank Securities

Jack Murphy – William Blair & Company

Jim Friedland – Cowan and Company

Lorraine Maikis – Merrill Lynch

Imran Khan – J.P. Morgan

Matt Nemer – Thomas Weisel Partners

Blue Nile, Inc. (DF) Q3 2008 Earnings Call November 4, 2008 5:00 PM ET

Operator

Good afternoon ladies and gentlemen. My name is [Marcello] and I will be your host operator on this call. (Operator Instructions) At this time I would like to introduce Eileen Askew, Manager of Investor Relations of Blue Nile. Miss Askew, you may begin.

Eileen B. Askew

Thank you. Good afternoon and thank you for joining us on our conference call today to review our third quarter 2008 financial results. With me today are Mark Vadon, Executive Chairman; Diane Irvine, Chief Executive Officer; and Marc Stolzman, Chief Financial Officer. All will be available for Q&A following today’s prepared remarks.

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 margin, expenses, net income, operating cash flow, capital expenditures, international growth, tax rate, stock based compensation expense, and other financial statement or balance sheet items, as well as statements about the global economic environment, diamond and metal prices, the stock market, the credit market, consumer behavior, currency, competition, our market share, our future plans and objectives, beliefs, 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 publicly update or revise these statements. Our actual results may differ materially and adversely from any projections and forward-looking statements discussed on this call.

Our quarterly reports on Form 10-Q, our annual reports on Form 10-K 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 free cash flow which is defined as net cash provided by or used in operating activities for operating cash flow, less outflows for purchases of fixed assets including internal use software and website development. We will also discuss non-GAAP adjusted EBITDA which is 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 Diane Irvine.

Diane Irvine

Thank you Eileen. Good afternoon everyone. I know you’ve had an opportunity to review the press release we issued this afternoon. We will focus our remarks today on the following five key areas. First we will review the macroeconomic environment and its impact on our business and our outlook. Second we will review the diamond pricing environment. Third we will review the strength of our business model and comment on the competitive landscape.

Fourth we will review our key initiatives and how we are managing the business in this climate. And fifth we will discuss our business results and profitability for the quarter. As stated in our press release, the third quarter was a challenging one. The extensive weakening of the U.S. economy and tight credit conditions faced by consumers hampered our growth. In addition diamond prices were up nearly 20% over year ago levels. This was the highest year-over-year diamond price increase in the history of our business.

These two factors, the economy and increased diamond prices, combined with consumer confidence at historic lows led to the decline in sales. While we are disappointed with these results, we are confident in the fundamentals of our business model and remain focused on executing our key initiatives. We are prioritizing projects that focus on the customer experience and are managing costs in a disciplined manner.

Despite the environment we delivered profits within our guidance range and positive free cash flow. I’d like to provide our perspective on the macroeconomic environment and its impact on our business and our outlook. We’ve seen incredible turmoil in the global financial markets in the past seven weeks. In the face of this turmoil, consumer spending and confidence have fallen precipitously. In the third quarter consumers in the U.S. reduced spending by the largest amount in 28 years. Throughout all of retail consumers were cutting back even more in October.

The severe tightening in the credit markets has had a significant impact on consumer purchase behavior across the entire retail landscape. The credit freeze has impacted the purchases of high ticket items as traditional avenues of financing have closed. For example, financing that was once coming from stock market gains, home equity loans, and abundant credit availability through credit cards is either no longer available or has become severely restricted.

The psyche of the consumer has been badly damaged, with October posting the lowest consumer confidence level on record. While our third quarter sales declined by 2.9% overall, published reports indicate that total Internet jewelry sales declined 11% year on year in the quarter. At Blue Nile we have seen our sales weaken in the past seven weeks, following the unprecedented events in the financial markets beginning in mid-September.

For the month of October, our sales were down 20% year on year. Given the events that have taken place in the global financial markets, consumers are understandably reluctant to spend. As the financial crisis has spread from the U.S. to other parts of the world, sales growth in our international business has slowed. Our international sales grew 53% year on year in the third quarter. Strong relative growth but down from our 179% growth rate last quarter.

The deteriorating global economy, coupled with the strengthening of the U.S. dollar, caused our international results to be more muted than those delivered in the first half of the year. With the buying power of currencies in our international markets declining roughly 20% versus the dollar, in combination with diamond prices increasing 20% year-over-year in dollar terms, consumers outside the U.S. saw extremely sharp increases in jewelry prices in Q3.

In addition, it’s important to note that the third quarter was the first full quarter in which we had anniversaried the May, 2007 introduction of our local currency websites for Canada and the UK. While we are experiencing some short term headwinds in our international business caused by global economic conditions and currency changes, we continue to be very enthusiastic about the future opportunity for our international business given the exceptional consumer value proposition that we offer.

Looking ahead, the economic climate remains extremely difficult. We are approaching the upcoming holiday season very cautiously. We will be sharp on price and value and will use this as an opportunity to enhance our competitive position. Current sales trends are very unclear. We don’t have a good picture as to how sales levels for the remainder of the quarter will compare to sales levels in the month of October.

While we would prefer to provide Q4 guidance, we have very little clarity as to how the economic environment will impact consumer spending patterns for the holiday season. For these reasons, we have decided that the prudent course is to not provide financial guidance for Q4.

Let me now turn to diamond pricing, our second key point. In late May there were significant wholesale price increases for diamonds. In the third quarter diamond prices were up approximately 20% from a year ago. This had a negative impact on consumer demand in the second and third quarters. As we explained on our last quarterly call, with our Just In Time model for purchasing diamonds, changes in diamond pricing from the supply chain are quickly passed on to our customers.

Throughout our history, we have seen a strong correlation between our sales growth rate and movement in diamond prices with our sales grossing strongest when prices are declining, even relatively stable to moderately rising. In any period of economic uncertainty, it’s a good thing to not hold significant inventory. We love operating within our low inventory model in the current environment.

As I mentioned earlier, our model benefits in periods when prices are decreasing and there are some signs that we may be entering such a period. The weakness in the economy appears to be having an impact on the diamond supply chain and many industry sources are anticipating a decline in diamond prices. We have begun to see diamond price decreases over the past couple of weeks.

While we cannot predict what will happen with diamond prices over the next quarter or beyond, we believe that our business will benefit significantly from lower diamond prices as we will pass those savings on to consumers in the form of lower pricing on a real time basis. We are ready to capitalize on this market dynamic should diamond prices continue to decline.

There was also some good news with respect to metal prices. Gold prices at the end of the third quarter were up approximately 20% year-over-year but have retreated since then. Platinum and silver prices declined during the third quarter and are now well below the highs reached during the first quarter of 2008. These declines in prices are beneficial for our business and our customers. We are committed to providing consumers the best value in the industry and we know customers are looking for that value now more than ever.

We believe we will have an opportunity to lower prices on some of our platinum and gold jewelry items heading into the holiday season. I’d like to move on to our third key point, the strength of our business model and a review of the competitive landscape. We are confident in the fundamentals of our business model. In this environment, our superior business model is our number one strength. We are financially strong with a lean cost structure and a capital efficient business model that is differentiated from our brick and mortar competitors.

Throughout this year we have operated in a disciplined and conservative manner in our business execution. Our focus is on delivering exceptional products at an outstanding value to our customers. We believe that this focus, combined with our discipline in running our business efficiently, will enable us to capture market share and enhance our consumer experience while many of our competitors are forced to pullback in this environment.

Let’s take a look at the overall retail jewelry environment in the U.S. On a year-to-date basis through Q3, more than 3% of the capacity of the jewelry industry has been removed through store closures, consolidations, and bankruptcies. Many stores are liquidating inventory at heavy discounts. We believe there is much more shake out to come. The retail jewelry environment in the U.S. has worsened in the past quarter and we believe the competitive landscape will look very different in the future.

This environment is extremely tough for brick and mortar jewelers. They are holding significant inventory at a time when consumer demand is weak and commodity prices are falling. We believe that the weak players will fail, there will be additional consolidation in the industry, and Blue Nile will continue to take share. We are extremely well positioned in this environment. Blue Nile is financially and competitively strong.

We believe that the strength and benefits of our unique business model allow us to navigate through these challenging conditions. For example, we can operate profitably even in a situation where sales decline at the level we saw in the month of October. This means we can emerge even stronger when the economy begins to improve, while many competitors will have gone out of business.

I would now like to move on to our focus on our top business initiatives, our fourth key point. We believe it is critical, especially during this economic downturn, to invest in enhancing the Blue Nile customer experience and we are doing just that. Investing in the customer experience is paramount to building a lasting brand. In this area, we have focused on making every customer interaction with our expert diamond and jewelry consultants a great one, emphasizing our commitment to service that exceeds our customer’s expectations.

Turning to our website, we have made and continue to make significant enhancements this year. Last quarter, we launched live help on our website, providing another way for customers to interact with Blue Nile. Our customers have enthusiastically adopted this option of speaking with our diamond consultants via live text chat during their purchase process. Also in the third quarter we re-launched our diamond search functionality with a number of user interface best practices that provide contextual education to assist consumers in selecting the perfect diamond.

With these recent enhancements, we continue to empower customers with information and guidance throughout their shopping process. Last week, we introduced an enhanced search process for engagement ring settings that organizes our more than 150 settings into categories to help customers quickly find the style of ring they are seeking. Each of the categories showcases distinctive styling and points of view in order to assist customers in their selection process.

We will continue to make improvements to this new functionality over the next month as we move into the holiday season, the most popular time of the year for getting engaged. Looking ahead, we will introduce enhanced imagery to provide our customers with even greater flexibility and visualization capability as they build customized engagement rings and shop for jewelry. We must continue to raise the bar in all aspects of our website and the Blue Nile customer experience as we pursue our goal to further extend our lead in the online jewelry category.

In today’s marketplace it is especially important that we provide an exceptional customer experience along with our compelling value propositions in order to capture market share. On the product side, we are focused on offering more of the beautiful high quality products for which we are known. As we head into the holiday season, we have added new merchandise in a wide range of price points to help our customers find the perfect gift.

While other jewelers are liquidating inventory and reducing assortment in response to economic pressures, our product selection this year will be our strongest ever. We have added to our diamond band collection with more styles in pave and micro-pave as well as channel set diamonds with a special focus on eternity bands. These bands are very popular for engagement, wedding, anniversary and just because.

We are introducing greater selection in settings from platinum to white gold, from the most classic solitaire to intricate micro-pave designs. New pearl and diamond jewelry is being added, as well as beautiful gemstone jewelry in earrings, pendants, and rings. In addition, we will offer an entire collection of jewelry that can be personalized with engraving, from charm bracelets to lockets which are very popular during the holiday season.

Another offering that we introduced during the third quarter is a new financing option for our customers through Bill Me Later. This new offering provides an additional payment method for our customers who have been challenged by the tightening of the credit market. Bill Me Later offers a 90 day, same as cash option that has been well received by our customers. We believe this will be a great offering throughout the holidays.

Another key initiative is to build out our international business and expand our geographic penetration. We believe the opportunity for our business internationally is tremendous and we have barely scratched the surface. This year we expanded our shipping capabilities to over 25 new markets in Europe and Asia, Asia-Pacific, and we have been learning and monitoring our customer activity to form our strategy for future growth.

In 2009 we intend to improve the customer experience in our top new international markets with language and currency localization, along with the expansion of our product assortment. These enhancements will be systematically rolled out with priority on the markets with the greatest potential for growth. As we approach the holiday season, we are confident in our ability to execute, but we are being appropriately cautious in our planning.

There is no certainty about how the economic crisis will impact consumer spending for the holiday season. We are taking steps in our planning to allow for ample flexibility in capacity, inventory, and cost management to scale the business to the volumes we are generating. While this is a difficult environment for luxury retail, our business model is profitable and we continue to generate healthy cash flow.

Most importantly, we believe our value proposition resonates with consumers at all times but perhaps especially during difficult economic times. We remain confident in our ability to gain market share in this environment and believe that we are well positioned to emerge even stronger in an industry that continues to consolidate. I’d now like to turn the call over to Mark Stolzman to review the details of our quarterly results.

Mark D. Stolzman

Thank you Diane and good afternoon everyone. In the third quarter we posted sales of

$65.4 million a decrease of 2.9% from the third quarter of 2007. The decrease in sales was due to an almost 6% decline in total orders, offset by a 3.1% increase in our average order value. Our average selling price per order was $2,159 in the third quarter. On a geographic breakdown, U.S. sales declined 7% while international sales grew 53% year-over-year. Sales from our international market now account for just over 10% of net sales.

Consistent with reports from other retailers, our sales were especially weak in late September following the dramatic events in the financial markets during that period. Looking at the performance of products across various price points, we continued to see a slow down in the price points between $5,000 and $25,000. These are aspirational price points where we believe access to credit and customers trading down are hampering the growth in this category. We also experienced softness at the very high end, those above $100,000.

Sales at the price points below $5,000 as well as in the $25,000 to $100,000 range grew year-over-year. Gross profits for the quarter was $13.3 million. As a percentage of sales, gross margin for the quarter improved to 20.3% compared to 19.8% in Q3 2007. The year-over-year improvement in gross margin is a result of product mix shifts. Our non-engagement jewelry category experienced modest growth for the quarter and this category carries a higher average gross margin than the engagement category.

Net income for the quarter was $2.3 million. Earnings per diluted share were $0.15 meeting the low end of our guidance range. We were pleased that through our focused control of operating costs as well as improvements in our gross margin, we were able to deliver these results. Net income per diluted share for the quarter includes stock based compensation expense of $0.07 compared to $0.05 for the third quarter of 2007.

SG&A totaled $10.0 million for the quarter. SG&A included $1.6 million in stock compensation expense in the third quarter of 2008, compared to $1.4 million in the third quarter a year ago. Excluding stock based compensation expense, SG&A as a percentage of sales was 12.9% compared to 12.5% in the third quarter of 2007. Third quarter results include higher year on year costs associated with last November’s expansion of our domestic fulfillment center.

Operating income for the third quarter totaled $3.3 million representing an operating margin of 5%. 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, was $5.4 million for the quarter consistent with the third quarter of 2007.

Maintaining our adjusted EBITDA with last year’s levels despite lower sales showcases our disciplined approach to cost control and our business model’s ability to continue to generate cash flow. Additionally, unlike many of our brick and mortar competitors we have no leverage on our balance sheet. This enables our net income to remain strong in a declining sales environment when others would be more severely impacted.

Interest income totaled $184,000 for the quarter, compared to $947,000 in last year’s third quarter. The decrease of interest income is due to lower interest rates and a lower average cash balance compared to the third quarter of 2007 as a result of our share repurchases. Our effective tax rate for the quarter was 34.4% compared to 35.0% a year ago. We ended the quarter with a cash balance of $26.6 million. During the quarter we repurchased 593,700 shares of our common stock for a total of $23.2 million.

Over the past 12 months we have been very active in repurchasing shares. At the end of September, 2008 our shares outstanding totaled 14.5 million compared to 16.0 million a year ago. Since the inception of the buyback program in the first quarter of 2005, we have repurchased 4.4 million shares for a total of $160.0 million. This amount represents 25% of the shares outstanding at the inception of the program. Our share repurchase program continues to be a priority for our uses of cash and we will look for opportunities to strategically execute our repurchase program.

Looking at the statement of cash flows, our trailing 12 months non-GAAP free cash flow for the third quarter totaled $20.1 million, down from $29.4 million in the year ago period. Due to our slower growth rates in 2008, we have generated less cash from our negative working capital model as compared to prior years. While the trailing 12 months figure has declined compared to the year ago period, the negative working capital structure and the cash generating capability of our core business model have us well positioned to withstand the current economic uncertainties.

On the topic of our outlook, as Diane discussed and as we announced in our press release today, we have withdrawn our fourth quarter and our full year guidance and are not providing sales, non-GAAP EBITDA and EPS guidance due to the deterioration in the economic environment and the uncertainty surrounding consumer spending patterns. Additionally, the fourth quarter is our largest revenue quarter of the year making estimates even more difficult to calibrate.

I would like to remind you that we operate on a 52/53 week fiscal calendar and this fiscal year is a 53 week year ending on January 4, 2009. For 2008 our stock compensation expense is estimated to be $0.28 per diluted share which is $0.06 higher than stock compensation expense in 2007. We have lowered our capital expenditure expectation for the year to $2.0 million compared to our prior plan of $2.5 million. The reduction is due to the change in the priority and the timing of our projects.

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

Diane Irvine

Thank you Marc. In summary, we are confident in the strength of our business and our ability to gain share during this challenging period. Our business model clearly sets us apart from the competition. We will maintain our intense focus on executing with excellence during the upcoming holiday season. With that, we would be happy to take your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Doug Anmuth – Barclays Capital.

Doug Anmuth – Barclays Capital

In terms of working capital, can you just give us a sense of whether suppliers are changing their terms at all in terms of needing their cash any sooner in the current environment? And is there anything structurally different about your ability to generate free cash flow now other than the slowdown and actually the decline in sales? And how much cash do you think is needed to run the business? What’s sort of the minimum that you think about on the balance sheet?

Diane Irvine

If you look at supplier terms, no we haven’t changed terms and if anything I think as we’ve discussed over time we have extended our terms each and every year. And that continues. In terms of things being structurally different, I’ll let Marc comment but I think what Marc was saying is if you look at with floater growth you don’t have the same dynamics in the negative working capital. But in terms of our ability to generate free cash that’s certainly there very strongly in the business.

As to how much cash we need, I think certainly at current levels we feel great about our cash position and it will continue to build, as I discussed even in the case of with the month of October where we looked at that level. So I think our model allows us to continue to generate profitability and free cash and you just don’t have that same dynamic in the negative working capital.

Marc D. Stolzman

I think the only thing I might add is that the EBITDA year-over-year is very much a factor of maintaining the variable expenses within our model. And we seek very strongly to control that in consistent with our sales. The free cash flow dynamics, inventory versus our accounts payable, are usually a shorter term factor of either rising or falling sales and then it re-stabilizes so that the underlying EBITDA and cash flow generation are very consistent.

Operator

Your next question comes from Mark Mahaney – Citigroup.

Mark Mahaney – Citigroup

That 20% year-over-year decline in October, was that U.S. or was that a global number? And then if – are there incremental steps you’d want to take over the next six to nine months to more aggressively take market share? Or do you just run the business as is and as traditional retailers some likely have to fold up you’ll just take that market share as it comes? Or do you want to try to accelerate that market share gain?

Diane Irvine

In terms of the October number that was our total business, the negative 20%. And in terms of steps to take share I think everything that we’re doing is really designed to do that, Mark, and especially as I mentioned if we see diamond prices fall that will be hugely beneficial to our business. Because again we’re passing those savings on to consumers on a real time basis as we buy diamonds each and every day. So I think that would be very dramatic. Just the opposite of the dynamic you saw in Q3 with the significant year on year price increases.

In addition to that, we’re being very sharp today in terms of price. I think our assortment will be fantastic during the holiday season. So I think we just need to continue to do what we’re doing and to convert the customers who are in the marketplace because there’s no place else they should be going if they’re in the market based on a proposition here.

Operator

Your next question comes from Herman Leung – Deutsche Bank Securities.

Herman Leung – Deutsche Bank Securities

I was wondering if you could talk about the levers that you have on the gross margin side. I know you guys are shifting I think some of the product mix from the higher end of products down to more of a lower end product indicated by some of the price cuts we’re seeing over the past several months. I was wondering if you could talk about the margin levers that you have in the business, especially in the fourth quarter. And the second one, was wondering if ESP’s kind of held up pretty nicely in the third quarter up 3% but was wondering if that would be a decline – expectations of a decline going into the fourth quarter?

Diane Irvine

Herman I’m not sure if I understood the first part of your question so just please chime in if I don’t quite get it. In terms of levers on gross margin, I mean one of the things that you saw on the quarter which Marc talked about was really our mix. And so as you look at going into Q4 like with ASP for example, you will expect a different ASP quarter to quarter. I don’t know if you’re asking year on year because the mix will be less engagement as a percentage of total than it was in Q3.

Where generally in Q3 you’d have a higher engagement mix which would carry with it a lower gross margin percentage and higher average ticket. And then in the holiday quarter in Q4 engagement is less a percentage of our total. So it’s all mix related but I’m not sure if that’s what you’re asking when you talk about margin –

Herman Leung – Deutsche Bank Securities

I was actually referring to the year-over-year.

Diane Irvine

Yes, I mean year-over-year obviously we’re trying to drive the margin dollars here. And so I think you know we did that very well in terms of being able to show improvement year on year with margins pretty steady, product category by product category on a year on year basis. And so I think if we saw, for example diamond prices decrease, we might have year on year the same or slightly higher margins.

But we wouldn’t be taking that into our margin. We’ll pass it through. So I think our mindset is to be pretty steady year on year in terms of our gross margin percentage by category, but that said we will always look for opportunities if we can through the pricing lever to generate more profit dollars.

Herman Leung – Deutsche Bank Securities

You talked about some of the drivers of diamond deceler – prices of diamonds kind of decelerating the past several weeks and you guys are kind of confident there. Do you think that’s more of a function of a stronger dollar or do you think there’s an increased supply there?

Marc D. Stolzman

I think what you’re seeing there is suppliers are acting to very weak demand. And there’s obviously over the last couple of months very, very weak demand in the U.S. And then when you look internationally with the weakening dollar if you’re over in England and you were going to buy a diamond back in April or May of this year, diamond prices rocketed up in May by up to 20%. And then as the summer wore on the purchasing power of your currency went down by 20%.

So effectively in six months the price of diamonds in the UK and in a lot of those other markets went up by about 45%. So that obviously has led to weakening demand overseas. So I think the supply chain is just faced with a rather sharp downturn in demand for diamonds and that’s translating through to prices. So you know what we’re seeing over the last few weeks and you know this summer, if you look at year on year changes with diamond pricing, this summer was the largest increases we’ve seen in the entire history of the business.

And now all of a sudden within the last seven weeks, at first you go back to mid-September people weren’t reacting. But just over the last couple of weeks, as people in the chain see demand weakening they’re starting to take prices down. And this last Friday we saw the wholesale price list, the Rapaport price list take a pretty big step down. But that list has just been going up consistently for quite a time and prices decreased by roughly 5 to 8% on Friday. And before that decrease came in, people were already taking their prices down.

Buyers were taking their prices down then on Friday that change happened and that kind of amplified the changes that were happening in the – the decreases people were already taking. So the first indication, it’s only a couple weeks there, but the first indication is that we’re seeing diamond prices may be having peaked and starting to move down. When you look at metals it’s the same thing I think. If you go and look at a chart of platinum, platinum earlier this year was at $2,200 an ounce. It bottomed out here at roughly $750 or so. It’s probably at $800 or $900 today.

So as we’re bringing in new products in platinum, things like wedding bands, are priced at a fraction of what they were earlier during the year. So I think all of that hopefully translates through to some much better pricing for consumers and there’s going to be a little bit of a tailwind which right now we really need.

Operator

Your next question comes from Jack Murphy – William Blair & Company.

Jack Murphy – William Blair & Company

Could you give us a sense of the variable versus fixed expense mix within the SG&A line and is there a significant difference between how you look at that on a full year basis versus the fourth quarter with a larger amount of sales?

Diane Irvine

If you look at the variable costs, Jack, in terms of marketing it might be different quarter-to-quarter but roughly speaking you’re looking at kind of 4, maybe 4.5% of revenue. We have a couple of points related to payment processing fees, credit card charges. We have a couple of points related to variable costs in customer service fulfillment. And then what we consider to be a couple points of semi-fixed costs across the business where in any department we might be needing to add.

In Q4 you see some leverage there, but essentially we kind of look at that as roughly 10 points of variable costs in the business. So I think to Marc’s point, we can manage the business because we’re so much variable cost based that we are able to move and manage well, I think, in a very disciplined way as we go through times where volume is higher or lower. And that’s what we need to continue to do.

Jack Murphy – William Blair & Company

Regarding the international slowing, obviously still high in absolute terms in terms of growth but relative to last quarter, was the deceleration more – was it widespread or fairly even? Or were the markets that you’ve been in longer like the UK and Canada materially different when you just look at the slowing?

Diane Irvine

It was widespread, Jack, especially as we went through the quarter and then as you got towards the end of the quarter where you really saw the currency changes, you know, that had an impact everywhere. But again we love those markets and we’re very excited about the new markets. But that currency change when Marc puts that in terms of if your diamond is going up 45% in that short period of time, that’s very difficult. But it was a widespread change.

Jack Murphy – William Blair & Company

I realize you don’t have specific guidance but you did mention that you can generate free cash flow even in a difficult market. Is there anything you can say in broadly about free cash flow in fourth quarter relative to last year or the $37 million full year last year? Just even in the broadest terms?

Diane Irvine

I wish I could, Jack. That’s very difficult right now. What I would say though is if you look at any period on a quarterly basis there would be timing issues related to the free cash flow and so if you just take kind of a normalized environment which we really hope for here, to be coming soon, the pattern of sales that’s in the quarter as well as the sales mix will help determine kind of where that negative working capital comes in.

And then what your trends are, are you accelerating or decelerating or kind of having equivalent levels of sales just going through the quarter? That will determine how much accounts payable gets built up during the quarter. So in a normal time it’s dependant upon all of those trends. And so I think the working capital piece is the part now, based on sale growth, that’s a little acting differently than we’ve seen in the past.

Operator

Your next question comes from Jim Friedland – Cowan and Company.

Jim Friedland – Cowan and Company

First on repeat sales, just looking at the 500 basis point improvement in gross margin and where that’s coming from, is it safe to assume that as part of this going through this issue in the economy that repeat sales are going up as a percentage of total more than they have in the past? And then the second question is on marketing expense. What are you seeing out there particularly in the online channel in terms of pricing? Are you able to pay less in terms of cost per acquisition and search? What are you seeing in this way or even in your offline channels?

Diane Irvine

Jim, in terms of repeat sales I think if you look at the business, generally we’re very much about new customer acquisition as engagement is such a significant part of our business. And engagement has been a bit weaker than the non-engagement part of the business. The non-engagement is fueled more by the repeat business. So I think that’s how I would look at kind of what our trends have been this year.

Where it really is that engagement customer kind of in those aspirational price points that Marc talked about, where the entire credit freeze, I think, really has an impact on that market.

Jim Friedland – Cowan and Company

And on the marketing cost?

Marc D. Stolzman

On marketing I don’t think we want to go into tremendous detail there but I would just say overall the online marketing costs were remaining strong as we worked our way through the year. And we’re starting to see that change now, especially in some of the marketing channels. I would just say people are willing to negotiate pretty hard right now. We’re seeing availability of marketing inventory for the Christmas period that in most years we would’ve – it would have been sold out many, many, many months ago.

So we kind of feel that people are starting to pullback and starting to cancel placement and things like that. So I think there is some sign that that’s starting to weaken.

Jim Friedland – Cowan and Company

In the search part of your business going back, it was probably two or three years at this point, at one point some of the bigger brand name department store type companies were coming in and bidding in extremely high prices and you had said that that had actually improved over time. Are you seeing on the search side or are they starting to bow out of the market? Or is search still competitive?

Diane Irvine

Search is still competitive. I think in some areas of marketing as Marc said we are seeing some softening. I think in Q4, though, we always expect that there’ll be competition because of the holiday season. And over time, quarter to quarter, you’ll see different players come in and out. But if you look at it broadly, those prices are still moving up.

Operator

Your next question comes from Lorraine Maikis – Merrill Lynch.

Lorraine Maikis – Merrill Lynch

You’re entering the holiday season with a higher level of inventory than it appears your sales are trending at. I just wanted to ask how comfortable are you with the content and then also how much more are you skewing toward non-engagement going into this holiday versus last year?

Marc D. Stolzman

I think in terms of our overall inventory, both in terms of quantity and selection, I think we feel very good. You are right. We are entering the quarter with a higher year on year inventory, but I feel very comfortable that our management principles, both on a unit by unit basis and overall by category, that we think that we’ll be able to manage that component of both product selection and working capital fine.

Diane Irvine

Then in terms of engagement versus non-engagement, Lorraine, I’d say if you look at our inventory at any point in time, there’s a portion of it that would be settings, the ring settings for a diamond engagement. And generally speaking of course we’re not holding the diamonds in our inventory, but we are holding the settings. So I’d say it’s really consistent with what you’ve seen in the past, where what’s in our inventory would be settings and then in addition to that it’s everything else.

Its pearls, sterling silver, wedding bands, all of those items. And we’re very excited about this year’s assortment. And as we work in these times, we’ll manage that inventory well.

Operator

Your next question comes from Imran Khan – J.P. Morgan.

Imran Khan – J.P. Morgan

First I was wondering if you could give us some color the price that we talked about $5 to $25,000 where you saw some softness, what percentage of your sales come from that price bucket? And secondly a housekeeping question and I didn’t see it, 53% growth in international market, how much was foreign currency on that?

[Unidentified Executive]

I think on the first part that we don’t break out our sales mix by price point, so I won’t be able to provide additional color on that. In terms of foreign exchange, as Marc had mentioned, we did see foreign exchange headwinds within the quarter that would have impacted the overall growth, but we haven’t been broken out our foreign currency versus the overall organic component.

Diane Irvine

But we don’t have an FX component in our financials and so when you look at the growth rate it’s all sales growth.

Operator

Your next question comes from Matt Nemer – Thomas Weisel Partners.

Matt Nemer – Thomas Weisel Partners

My first question is can you talk to the mix of how people were paying for product, particularly towards the end of the quarter relative to either your B of A financing, their own credit card or I’m not sure if Bill Me Later was up and running at that point? But just the mix to financing during the quarter and towards the end.

Diane Irvine

Something we’ve talked about this year, Matt, is the financing program which we have had with Bank of America and now we have Bill Me Later, has declined significantly. As you’ve seen approval rates change and so I’d say that continued to be the case in the quarter. Bill Me Later was launched towards the very end of the quarter and so it’s been a nice offering, but by no means is it meaningful in these numbers. The vast majority of our sales take place by credit card and then a significant amount through bank wires where we offer a discount.

But I think the real issue even beyond having a financing program is that with respect to credit card limits, in this environment with credit card limits being brought down, I think that impacts all customers whether or not they’re looking for a financing type program. But just kind of the credit availability.

Matt Nemer – Thomas Weisel Partners

I’m sure you track those declines and have you seen credit card decline rates move significantly higher? Where maybe the customer isn’t aware that their limit has come down on them?

Diane Irvine

No, we haven’t seen that, but certainly for customers I think kind of when they get their statement they might be finding that their credit limit was a bit lower than it used to be.

Matt Nemer – Thomas Weisel Partners

You mentioned during the holidays you plan to be sharp on price and value. I’m just wondering how you plan to monitor that and what you’re benchmarking against. Is it other online retailers? Is it some of the offline retailers? Will you try to be competitive with – given some of the liquidations and other things that are going on out there, how can you be?

Diane Irvine

Yes, I think we’re always monitoring. We’re looking at our value proposition primarily versus offline, because that is the real competition and it’s kind of the independent jeweler in any city across the country. And we also monitor versus online. I think when we look at being sharp it’s looking at kind of what is our price? So if you take this diamond pricing situation, we’ll look at where can we provide value to consumers? And to some extent we’re always looking at categories of diamonds and adjusting price.

And with any of our products, for example in the metal products now which Marc discussed if you look at wedding bands or with the metal prices coming down we have [inaudible] those prices so I think we’ll just look at what is our sales volume? Where do we think we can maximize our profit dollars if we lower price by a bit? Or make adjustments? So I think we’ll be doing that on a fine tuning basis as we go through the quarter. Because that situation is so dynamic in terms of all those commodities pricing.

Matt Nemer – Thomas Weisel Partners

In terms of your diamond vendors, can you give us some insight into how they finance their business? Are they financing inventory internally? Do they use third party financing? And how much risk is there if they were buying product during the spike and their prices for them are now down 5, 10% plus?

Diane Irvine

Well I think broadly if you look at the entire industry, diamond and jewelry, whether it’s a manufacturer or a retailer, there’s credit throughout the industry. There’s a lot of leverage. In terms of our own supply base, I think we have a very diversified base of suppliers globally.

Matt Nemer – Thomas Weisel Partners

I know that this is – you may not have an answer to this question yet, but in terms of 2009 guidance do you anticipate providing that during the fourth quarter? Or is it sort of a wait and see approach at this point?

Diane Irvine

Well while we’ve traditionally done actually as we haven’t ever provided that in a Q4, we’ve always waited until the holiday season and provided that at the beginning of the year. And I think we’ll kind of see what transpires in the external environment. Really as we look at this, all of these external factors we can’t predict. It’s out of our control. So we’ll manage the business as best we can and then when we get beyond Q4 and we put that to you, I think we’ll let you know at that time our thoughts on guidance.

Operator

And ladies and gentlemen, we have reached the end of the allotted time for questions and answers. Miss Irvine, do you have any closing comments today?

Diane Irvine

Thank you all for joining us today and we’ll look forward to talking to you again next quarter.

Operator

And this does conclude today’s conference call. We’d like to thank you for your participation and ask that you now disconnect.

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Source: Blue Nile, Inc. Q3 2008 (Qtr End 9/28/2008) Earnings Call Transcript
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