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Blue Nile Inc. (NASDAQ:NILE)

Q2 2006 Earnings Conference Call

August 1, 2006, 5:00 pm ET

Executives

Mark Vadon - CEO

Diane Irvine - CFO

Nancy Shipp - IR

Analysts

Scott Devitt - Stifel Nicolaus

Jim Friedland - SG Cowen & Company

Mark Mahaney - Citigroup

Dan Geiman - MacAdams Wright and Ragen

Doug Anmuth - Lehman Brothers

Christine Korber - JMP Securities

Jim Hurley - Telsey Advisory Group

Presentation

Operator

Good afternoon. (Operator Instructions). At this time, I would like to introduce Nancy Shipp, Director of Investor Relations of Blue Nile.

Nancy Shipp

Good afternoon and thank you for joining us on our conference call today to review our second quarter 2006 financial results. With me today are Mark Vadon, Chief Executive Officer of Blue Nile; and Diane Irvine, Chief Financial Officer.

During this call, we will discuss non-GAAP financial measures to supplement Blue Nile's consolidated financial statements presented in accordance with Generally Accepted Accounting Principles. We will discuss non-GAAP free cash flow, which is defined as net cash provided by or used in operating activities or operating cash flow, less outflows, purchases of fixed assets, including internally used software and web site development. We will also discuss non-GAAP net income, which is defined as GAAP net income plus FAS 123 R stock-based compensation expense and the related income tax effects. Lastly, we discuss non-GAAP SG&A costs, which is defined as GAAP selling, general and administrative expenses, excluding stock-based compensation, and non-GAAP G&A costs, which is defined as GAAP SG&A, excluding stock-based compensation and marketing expense.

We report these measures to provide an additional tool to evaluate our operating results and financial condition. Please refer to our web site at www.BlueNile.com to obtain a copy of our non-GAAP financial measures, which contains a full reconciliation of free cash flow, non-GAAP net income and non-GAAP SG&A to the nearest respective GAAP financial measure.

As a reminder, during the course of this call, we will make forward-looking statements, including without limitation, statements regarding expectations of future financial performance, net sales, gross margin, expenses, net income, operating cash flow, capital investments and other financial statements or balance sheet items; as well as statements about our future plans and objectives, beliefs, expectations, targets, goals, outlooks or predictions for the future.

These statements are only predictions based upon assumptions that are believed to be reasonable at the time they are made and are subject to certain risks and uncertainties. Actual results may differ materially and adversely from any projections and forward-looking statements given by management. Our quarterly report on Form 10-Q, our annual reports on Form 10-K, and other forms on file with the SEC identify risk factors and uncertainties that you should consider when making an investment decision regarding Blue Nile, and they may affect whether our forward-looking statements prove to be correct. We undertake no obligation to publicly update or revise these forward-looking statements.

At the conclusion of the call, we will conduct a question-and-answer session. During the Q&A session, we ask that you please limit yourself to one question out of courtesy to others.

During today's call, Diane will review our second quarter results and the key drivers behind our results. Then Mark will provide additional commentary on the business, including an update on our international business and our share repurchase program.

Now, I would like to introduce Diane Irvine, Chief Financial Officer of Blue Nile, to review our second quarter performance.

Diane Irvine

Thank you, Nancy. Good afternoon, everyone, and thank you for joining us today. I am pleased to report that for the second quarter we delivered exceptional growth in net sales and earnings, driven by strong consumer demand in our core product offering. We achieved net sales of $56.9 million, up 29.9% from the prior year. This represents our highest year-over-year net sales growth rate in the past six quarters.

Net income in the second quarter totaled $3.1 million or $0.18 per diluted share, compared to $2.8 million or $0.15 per diluted share in the prior year. Our net income included $892,000 of stock-based compensation expense under FAS 123 R, which Blue Nile adopted at the beginning of our 2006 fiscal year. Excluding this stock-based compensation expense and the related income tax effect, non-GAAP net income was $3.7 million or $0.21 per diluted share for the quarter.

Through the effective execution of our strategy, we delivered results well above the high end of the Company's Q2 guidance of $54 million for net sales and net income of $0.12 per diluted share. The majority of our over-performance on earnings per share was driven by strong business fundamentals, but there are a few additional items that I'd like to point out related to our Q2 results.

First, our effective tax rate of 31.7% in Q2 was lower than the 35.5% rate we had estimated. This added $0.01 to our earnings per share. Other income of $100,000 related to a legal settlement added approximately four-tenths of a cent to EPS. I want to point out that our share repurchases during Q2 were neutral to earnings per share, although they will be accretive to earnings over the long term.

In Q2, total orders increased 15.3% as compared to a year ago. Our average selling price per order was $1,637 in the second quarter, compared to $1,441 in the second quarter of 2005, an increase of 13.6%. Sales growth was strong across all of our product categories during the quarter.

Let's review some of the key drivers behind our second quarter results. First, our revenue growth accelerated due to a number of key initiatives. Among these initiatives is our aggressive pricing strategy for diamonds, which led to accelerated revenue growth in our core product offering. Our objective within our pricing strategy is to maximize our dollar profit growth and free cash flow. As you recall, we instituted lower pricing for our diamonds in mid-February, and we believe our diamond pricing strategy was very effective in generating profitable growth in the second quarter.

We are in the early stages of redefining the way consumers purchase diamonds and fine jewelry and as such, our business is very much about acquiring new customers and capturing market share in a competitive marketplace. We believe that our competitive pricing is an important element in building our business and gaining long-term market share.

In addition to our pricing strategy, we are putting great effort into maximizing conversion on our web site to drive profitable growth. We are doing this through continued web site innovations, including our interactive diamond search, which is industry-leading in its capabilities. We are listening to our customers and making continuous improvements to our new search functionality, which was launched in March of this year. We believe our diamond search functionality, which has received rave reviews from our customers, is contributing to increasing conversion rates and therefore to our growth.

In addition to our diamond search, we continue to enhance the user experience throughout our web site on an ongoing basis, providing more and better features and tools that assist customers in their selection process.

Investments in our key marketing initiatives are generating positive results and contributed to our Q2 performance. Our focus within each of our marketing vehicles is to generate a profitable return on our investment. With the rising costs of online marketing, we have maintained this disciplined approach. We continue to focus on optimizing all of our online marketing vehicles. This means constantly digging deeper and driving efficiency with data-driven analysis, testing and feedback.

Although the cost of online advertising has continued to rise, we increased the amount of traffic to our web site as well as our conversion rates in the second quarter.

Our year-over-year top line growth also reflects execution with excellence on behalf of our customers. We continue to do what we do best, and that is to offer an exceptional customer experience through an unmatched selection of high-quality diamonds, coupled with our unique diamond jewelry customization capability. Customers are embracing the truly differentiated experience we have created.

We focus relentlessly on the basics, the many details that make up the Blue Nile customer experience. This is the foundation upon which we have built our Company. We are building a growing base of customers who are passionate about Blue Nile and who are not only returning to purchase from us but are also referring their friends to Blue Nile.

I will now move on to review more of the financial details included in our second quarter results. Gross profit for the quarter was $11.3 million, compared to $10 million in the second quarter of 2005, an increase of 13.6% year-over-year. Gross margin for the quarter was 19.9%, compared to 22.8% year ago. The decrease in gross margin is primarily the result of the lower diamond prices that we instituted during the first quarter.

In addition, gross margins were negatively impacted by continued cost increases for gold, silver and platinum jewelry that we did not fully pass onto consumers in the second quarter of 2006.

Our Q2 results reflects our team’s focus on execution throughout the business. We performed well in managing through a challenging cost input environment to deliver outstanding results. We managed costs with great efficiency and discipline throughout our operation.

Overall, our G&A costs, outside of stock-based compensation costs, barely grew year-over-year in the second quarter while supporting sales growth of 29.9%. We performed at a high level for our customers and executed diligently on our fundamental business drivers.

Interest income was $881,000 for the quarter, compared to $559,000 in last year's second quarter. The year-over-year increase was the result of higher interest rates in the second quarter of 2006. Our effective tax rate for financial reporting purposes was 31.7% in Q2 2006.

Looking at our cash flow statement, I'd like to highlight the strength of our cash generation results for the second quarter. Non-GAAP free cash flow increased 47% to $29.2 million for the trailing 12 months, compared to $19.9 million for the trailing 12-month period ended July 3, 2005. Net cash provided by operating activities increased 43.9% to $31.1 million for the trailing 12 months, compared to $21.6 million for the trailing 12-month period ended July 3, 2005.

Over the past year, we have achieved significant improvements in working capital management, and we believe there's a lot of opportunity to continue to drive working capital benefits in our business model in the years ahead.

I'd like to point out some reporting changes in our statement of cash flows as a result of the adoption of the new stock-based compensation accounting rules. Prior to our adoption of FAS 123 R, any excess tax benefits related to stock-based compensation were presented as net cash from operating activities in our statement of cash flows. Under FAS 123 R, benefits related to excess stock-based compensation deductions are presented as cash from financing activities in the statement of cash flows. In effect, the new rules require a reclassification from operating cash flows to financing cash flows.

Tax benefits resulting from stock-based compensation deductions in excess of amounts reported for financial reporting purposes, which negatively impacted cash from operating activities in the first half of 2006 and which are reflected in our trailing 12-month free cash flow figures, totaled $569,000. It is important to note that there is no change in economic substance related to this change in reporting classification.

Taking a look at our balance sheet at the end of the second quarter, inventory totaled $11.2 million. Our average inventory turnover for the trailing 12 months at the end of the second quarter decreased to 16.1 times, compared to 17 times for the trailing 12-month period at the end of the second quarter a year ago.

We're very pleased with our performance for the second quarter and for the first half of the year. We believe our second quarter performance provides momentum for achieving our 2000 business and financial targets.

Looking ahead, I'd like to review our financial guidance for the third quarter and update our guidance for the full year 2006. For the third quarter ending October 1, 2006 we expect net sales to be between $49.5 million and $52 million. Net income is expected to be $0.09 to $0.10 per diluted share. This guidance includes the estimated impact of expensing stock options under FAS 123 R of approximately $0.05 per diluted share.

I want to point out several items that are important to understand in comparing our Q2 net income to our Q3 earnings guidance. Previously, I mentioned the lower effective tax rate and income from a legal settlement that resulted in an additional $0.014 of EPS for Q2. In addition, Q3 is typically our lowest volume quarter of the year on a seasonal basis and is therefore expected to have lower net sales and gross profit as compared to Q2. We also expect G&A costs to increase in Q3 related primarily to higher payroll expenditures and higher stock-based compensation expense.

For the full year 2006, we are raising our financial guidance. We expect net sales for the year to be between $240 million and $252 million, and we expect net income per diluted share to be between $0.67 and $0.74 for 2006. The estimated net income per diluted share includes the estimated impact of expensing stock options under FAS 123 R of approximately $0.17 per diluted share. Please note that we had previously estimated the impact of stock-based compensation expense at $0.14 to $0.16 per diluted share for the full year 2006.

We now estimate that stock-based compensation expense will be greater in the second half of the year than in the first half, due to the timing and amount of stock option grants as well as the assumptions used in valuing stock options. Actual stock-based compensation expense for the third quarter and full year 2006 will be based on the nature, timing and amount of stock options granted, the assumptions used in valuing these options, and other factors.

Capital expenditures for the year are expected to be in the range of $2.3 million to $2.8 million. Our 2006 capital expenditure expectations do not include any estimates for improvements that will be made to our fulfillment center under our new lease agreement that was signed on July 21. Our fulfillment center expansion will take place in 2007, and any related capital expenditures will be reflected in next year's total.

The effective tax rate for financial statement purposes for the second half of 2006 is expected to be approximately 35.5%. As a reminder, Blue Nile was not a full cash taxpayer for federal income tax purposes in prior periods, as a result of the carryforward of net operating losses. Our remaining net operating loss carryforwards are now almost fully utilized for tax purposes, and thus Blue Nile will be a full cash taxpayer for federal income tax purposes for most of the second half of 2006 and beyond.

I will now turn the call over to Mark to review his thoughts on the business.

Mark Vadon

Thanks, Diane. Good afternoon, everybody. Over the past seven years, we have built a great business. Internet Retailer magazine annually catalogs the 500 largest online retailers in the United States. In their most recent list, Blue Nile was the eighth largest pure-play online retailer in America. Every pure-play online retailer listed as larger than Blue Nile sells predominantly products developed and branded by other companies. Examples would include DVD players manufactured and marketed by Sony, or shoes developed and marketed by Nike. The retailers on this list do not focus on selling merchandise branded under their own name.

Blue Nile is different. Blue Nile is the largest pure-play business on the Internet retailer list selling its own branded merchandise. Building a business that sells products branded under your own name is difficult. It requires building consumer trust, both for your retailing ability and for your product itself. We believe this approach creates a more valuable long-term business. By delivering tremendous product quality and an unmatched buying experience, we believe we are early in the process of building an enduring consumer brand.

As part of our quest to continuously improve our business, we survey our customers several weeks after they purchase from us to understand their satisfaction with our products and with their buying experience. We ask customers to rate their overall experience on a scale of 1 to 5. In Q2, our average rating on customer experience was 4.53, up from 4.46 in Q2 of 2005.

During earnings calls, we rarely speak about individual consumer experiences, but today, I wanted to take a moment to read to you a couple of representative comments we have received from customers in the last few days. Most of our engagement customers write glowing reviews, such as the following from a customer in Lafayette, Louisiana:

"I visited many sites about selecting the correct diamond prior to start starting my shopping expedition. I visited many local jewelers and chain stores, and kept walking away disappointed at either the selection or price versus quality. I then came upon Blue Nile, and based upon reviews on other sites and the ability to design the perfect ring, I decided that shopping online was a possibility. Thanks to the comfort of the 30-day return policy, I shopped with confidence and found the perfect diamond and setting. My future wife loves her ring, and all her friends say I did an outstanding job. Thanks, Blue Nile. I would recommend you highly to everyone I know."

We have received comments like this for years. More interestingly, we now receive comments such as this one from a customer in San Diego:

"This is one of many purchases from Blue Nile for me. My fiancé purchased my engagement ring and wedding band from Blue Nile, and they are exceptional. This men's platinum ring is perfect for him. It's great weight and shiny. The items are always appraised for much more than the purchase price, and never fail to make us happy to glow about Blue Nile. I tell all of my friends and anyone who comments on my ring that Blue Nile is the place to shop for fine jewelry."

These are examples of the feedback we receive every day from customers who are ecstatic about their Blue Nile experience. It is validation for us that through the years of tremendous execution for our customers, we're building both a great retail business and brand that is trusted and respected by consumers.

One way to measure the amount of trust consumers have in Blue Nile is to look at how common truly high-end purchases are becoming for us. In Q2, we experienced seven transactions at price points above $100,000. I've never heard of another online consumer brand which frequently completes transactions at these price points.

I'd like to take a moment to discuss our international business. One of the next steps for Blue Nile is expanding our business internationally, taking what we have done for U.S. consumers to consumers in other parts of the world. Last year, we expanded our international offerings, and while the base of sales from these offerings is still small, we have seen tremendous growth.

In the second quarter, we generated approximately $1.9 million in net sales through our Canada and UK web sites. This represents 255% growth compared to the same period last year. Growth in this part of our business will increasingly become a priority for us as we enter 2007.

Finally, I'd like to provide an update on our share repurchase program. During the second quarter, we repurchased approximately 1.27 million shares, or 7.3% of shares outstanding, for an aggregate purchase price of $40.3 million. After these share repurchases, we ended the quarter with $56.4 million in cash and marketable securities.

Since the inception of our share repurchase program in February 2005 through the end of July 2006, we have retired approximately 12.6% of the outstanding shares of the Company for a total purchase price of $70.7 million. Q2 was the seventh consecutive quarter in which we reduced diluted shares outstanding. As of today, $47.2 million remains to be spent over the next 18 months under the $100 million stock repurchase program that we announced in February. We also announced today that our Board of Directors has authorized an additional $50 million in stock repurchases over a 24-month period.

Our share repurchase program underscores our commitment to enhancing value for our shareholders. Our strong balance sheet and continuing strong cash flows allow us to fund our operations, opportunistically repurchase our shares, and continue to grow the business for the future. We strongly believe that the repurchase of Blue Nile shares is a strategic means to create value for our shareholders.

In closing, I want to thank our investors and analysts for participating on today's call. As we reflect on our second quarter results, we're proud of the success we've achieved thanks to the hard work and commitment of our employees. Great teamwork and exceptional execution across the business led to our outstanding performance.

We will continue to focus for the remainder of the year on growth in our core business, enhancing the Blue Nile customer experience and building upon our industry-leading position in online diamond and jewelry retailing. We will, as always, remain disciplined in our focus on profitable growth while investing in the long-term opportunities of our business in order to deliver value over time to our shareholders.

This is the end of our formal presentation. We will now open up the call for any questions you may have. Operator, will you please poll for questions?

Question-and-Answer Session

Operator

(Operator Instructions). Our next question comes from Scott Devitt – Stifel Nicolaus.

Scott Devitt - Stifel Nicolaus

Thank you. First, I had a question about the average selling price in the quarter, which I think you said was up 14%. I'm wondering how much of that was the commodity cost increase versus maybe product mix changes? If you could give us a little detail on the product mix in the quarter, that would be helpful.

Mark Vadon

Sure. On the commodity price increases, that really doesn't have a lot of impact. What typically consumers are doing is coming in with a pretty fixed budget and purchasing accordingly. So if, for instance, diamond prices rise, consumers are trading down and it's similar in the precious metals. So if commodity prices rise, people will trade-off and instead of buying a platinum band, they might buy a white gold band. So as prices of commodities have risen, it really hasn't impacted the ASP.

The ASP was changed more by mix, both within products and across products. So as we got more aggressive on diamond pricing, for instance, that helps out our engagement business more than it helps out our non-engagement business.

We also saw some very high tickets, as I mentioned in my prepared remarks. I think what we're seeing over time is that the very high end, the exceptional purchasers, are increasingly trusting us, and we're seeing a lot of that. Our largest ticket this quarter was over $200,000, and we just saw a lot of activity. It felt like once every week or two weeks, we were seeing a six-figure transaction happen. When you start adding those up, it has an impact on the overall ASP.

Scott Devitt - Stifel Nicolaus

Then secondly, just backing into your second-half guidance, it seems like there's a pretty big drop in op income year-over-year 3Q to 3Q, and then in 4Q in starts to improve. I just wonder if you could talk through that? Is that related to lessening up on pricing or any changing in advertising programs? Is it possible that you've won the portal deal back this year that you lost last year?

Then the final question is just related to the number of shares that are actually outstanding as of this update and the release, because the number in the release I think is an average count, so I just want to, for modeling purposes, know how many shares are out. Thanks.

Diane Irvine

Thanks, Scott. In terms of the guidance for the second half, you know one thing I would say about the pricing of diamonds that we've done, we feel we're making the right decisions and we are continuing to find the right pricing levels for our customers. We did very well in the second quarter. I think we'll always be working on pulling the levers in the business. I think we feel like this is one quarter we don't want to get ahead of ourselves. We don't know any more today how the fourth quarter will turn out.

When you look at Q3 and the information I gave, you know, one of the biggest differences will be stock compensation expense. Previously we had given $0.03 to $0.04 impact and in this release, we indicated that will be $0.05. Then as I mentioned, somewhat higher payroll expenses, so you are right. Then, when you get to the volumes in Q4, then that starts to come back.

You also have to look at the fact that, in Q3, on a seasonal basis, you would have the lowest volume of the year and thus lower gross margins, so going from Q2 to Q3, there's a small impact there. But I would say we feel great about the momentum in the business and the growth there and the ability to generate strong earnings and cash flow.

Mark Vadon

I think, on the portals, we've made the decision not to give any more explicit color on different marketing vehicles. It just feels, competitively, the best thing we can do for our shareholders is to quietly execute in the background, especially cross-marketing vehicles without explicitly calling out on this call what we're doing.

On share count, I'm not sure, Diane, if we want to give color behind what we would expect in Q3.

Diane Irvine

Yes, in terms of at the end of Q2, Scott, our shares outstanding were 16.2 million. That will be in our 10-Q. In terms of Q3 obviously the drivers there will be any share repurchases that take place, as well as stock option activity, so I don't have a specific number to guide you to there.

Scott Devitt - Stifel Nicolaus

If I'm correct, that 16.2 is a basic number.

Diane Irvine

It is actual outstanding shares.

Scott Devitt - Stifel Nicolaus

Thanks.

Operator

Our next question comes from Jim Friedland - Cowen & Company.

Jim Friedland - Cowen & Co.

Thanks. First, again a question on the guidance. Clearly, Q3 is the slowest quarter for you guys but you had such a strong year-over-year growth in the second quarter; and given the fact that pricing is lower and it still should be I would say a relatively easy comp, the high end of the range indicates 24% year-over-year growth. Is that conservatism or is there anything else at work there?

Secondly, just a question on the traffic patterns on your site. You had noted increasing traffic and increasing conversion of that traffic. I was wondering if you could put any numbers on that -- like year-over-year growth on traffic and the conversion rate. Thanks.

Diane Irvine

Jim, in terms of guidance, you are right. The high end of our revenue guidance is plus 24%. We were about plus 30% in Q2. What I would say to that is are we being conservative? I think we feel, as you know, we are looking at our pricing and continuing to find the right levels for consumers. We had a great quarter in Q2 but I think we want to just continue to work that and not anticipate that every quarter is 30%; but I think at the same time, we feel good about the way the momentum is in the business.

Jim Friedland - Cowen & Co.

And on the traffic and conversion?

Mark Vadon

On traffic, we saw increases in traffic kind of in the mid to high single-digits. There was a research report that came out over the last couple of days which I think was citing a sharp decrease in traffic based on ComScore. In the past on these calls, we have cautioned people not to use ComScore because when we look at the numbers coming from ComScore, they don't reflect internally. So once again, we'd advise analysts and we’d advise investors who are reading these analyst reports to be careful about what you are extrapolating off of ComScore, because some of what was extrapolated a couple of days ago was not the best analysis. So, we just caution people to be careful.

Jim Friedland - Cowen & Co.

Mark, on the conversion rate that you are seeing, just the general trends there? Because you said it was increasing.

Mark Vadon

Yes, I think if you put together the number I gave on traffic and the ASP numbers we gave, you can find the increase there. But you know, it was pretty much a balanced effort between conversion and traffic this quarter for the improvement in number of orders out there.

Jim Friedland - Cowen & Co.

Okay, great. Thanks a lot.

Operator

Our next question comes from Mark Mahaney - Citigroup.

Mark Mahaney - Citigroup

I wanted to ask, Mark, a broad question about your pricing strategy versus marketing. What you've done in the last two quarters has surprised, perhaps, people by generating revenue growth off of lower gross margins. You've pretty effectively worked out this trade-off as marketing prices have risen.

Is that something that in the future that is still in flux, if search pricing, online pricing were to come down? Do you feel like you are in a position where you could just as easily turn up the gross margins, use pricing less? Or do you feel like, given the success of the last quarters, that you really hit on a fundamentally different strategy that we should expect for the next year-and-a-half, regardless of what happens to online advertising pricing?

Mark Vadon

Yes, I think our approach is really opportunistic. We're just looking to maximize the earnings and the free cash flow, and we're not wed to any particular margin structure to do that. So I think if we see ways to acquire traffic more inexpensively and we can make that trade-off to go to higher margins, we would do that if we felt the combination of the two produced better results.

I would say we've been very happy with the impact of the price change, though, and I think one of the side benefits, if it's a push between buying more traffic and pushing prices up versus the opposite, I think we'll stay with the lower margin structure. Again, if all things are equal.

Two reasons for that. One is it really benefits our consumers, and one of the things that we're seeing in Q2, we saw improved conversion. We were also seeing just really robust growth in our referral business. I think part of that is when consumers figure out the value that we are delivering, they get really excited about it; they tell people about it. So I think the lower pricing has a longer-term impact. It definitely works on the more viral nature. It also makes it more difficult for other people to compete against us.

I think, strategically, we are positioned really, really well. But if our economics are neutral between running on a lower gross margin and a higher one with a different marketing expense for each of those, I think it's a lot harder to compete with us at our current margin structure than at a higher margin structure.

Diane Irvine

Can I say, Mark, that our mindset is to drive pricing lower for our consumers over the long term, so I think that's something that we will always be looking at. It is a price-sensitive category and as Mark said, it's a great competitive lever as well.

Mark Mahaney - Citigroup

Then two other quick follow-up questions. Diane, just could you comment again on what you think free cash flow growth should be like for the year?

Then, in terms of the international markets Mark, you've consistently talked about the UK as being a 2007 opportunity. The first two quarters of this year showed this vastly accelerating revenue growth, albeit off of very small numbers. Why the wait until 2007 to try to do some fairly basic improvements, like put UK diamonds in pounds rather than in dollars? Why the delay until '07? Are you being cautious and you're trying to get to some sort of scale before you push that? Thanks.

Diane Irvine

Mark, on free cash flow, we don't guide to a specific number but what I would say is that you will see free cash flow growth that's strong over last year, even with the additional adjustment for the payment of cash taxes. So again, if I think if there's one thing that is underestimated about the business it is the cash flow generation capabilities. So while we don't guide to a specific number, I think we certainly believe there will continue to be strong cash flow generation and that you will see improvement above a year ago.

Mark Vadon

On the international, I'd just point to two things. We tend to be fairly conservative as a team here, and we want to be confident about opportunity before we push into it aggressively. I think we've gained that confidence, though. We are seeing, with very little marketing spending, consumers really adopting the UK web site. We are also seeing great growth in Canada, so we will invest behind those. Really, that was one reason for it.

The other reason is it's simply a matter of prioritizing technology resources. We remain very disciplined on the G&A side. What we don't want to do is show you guys huge increases in technology spending without seeing revenue or margin growth, and so we're staying disciplined there. Perhaps we should be a little bit more aggressive, but on the priority lists, those international web sites are coming up and we will start putting a lot more pressure behind those. Hopefully you'll see the results of that starting to build in 2007. That will get to be a meaningful number as opposed to being a small number with a lot of growth behind it.

Mark Mahaney - Citigroup

Thank you very much.

Operator

Our next question comes from Dan Geiman - MacAdams Wright and Ragen.

Dan Geiman - MacAdams Wright and Ragen

Good afternoon. You mentioned, Mark, I think the increase in the large-ticket purchases. I wanted to know what impact that might have had on gross margins? Also, if you could break down gross margins in terms of the impact that the commodity prices had.

Diane Irvine

In terms of the gross margin impact, Dan, there's some impact there but that's not significant. Really what you are seeing in the gross margin is the aggressive diamond pricing across the board. So while there is some impact also related to the commodity pricing, the bulk of that difference is related to our absolute pricing levels across all diamonds. So I think that's really the way to look at the gross margin level for the quarter.

Dan Geiman - MacAdams Wright and Ragen

Okay, so terms of some of these large-ticket items over $100,000 that really didn't have a significant impact then on your overall margins?

Diane Irvine

Correct, because we do have those size transactions on an ongoing basis, so while mix always plays a role, I would say that's about where we would expect the margin to end up, based upon our pricing strategies when everything blends together.

Dan Geiman - MacAdams Wright and Ragen

Okay, great. Thank you.

Operator

Our next question comes from Doug Anmuth - Lehman Brothers.

Doug Anmuth - Lehman Brothers

Thank you. Diane, you mentioned the interactive diamond search feature and I was hoping you could provide some more detail there in terms of at least qualitatively some of the comments and returns that you're hearing from your customers. Would you say that that was, at least in terms of site functionality, the single-biggest driver of the higher conversion rates? Obviously along with the lower prices. Then also, anything that you did specifically in Q2 around your search marketing efforts to improve your efficiency there? Thank you.

Diane Irvine

Sure, thanks, Doug. I will take the diamond search. In terms of conversion, certainly the diamond pricing plays a big role there but absolutely, the new diamond search functionality that we launched in March has been that next generation of diamond search for the business, and so it is driving higher diamond revenue per search and leading to higher conversions.

So what we've done there, we are hearing great comments from consumers who love the ability to customize. They can search based on whatever criteria they are interested in, well beyond the four Cs but looking at all of the dimensions and characteristics of the diamond, and they can continue to search on weight.

Another thing that we are able to do is receive feedback from consumers who are doing the search, so then as we hear from customers what additional features they would like, we continue to roll those out. So, I think that has been huge and really has made the next leap for us in terms of the ability for consumers to use our diamond search and select their diamond and create a ring.

Mark Vadon

One of the benefits we have, we have the largest audience by far of buyers for this type of product, and so we are able to do AB tests better than anybody else in the market. We are able to solicit feedback from people better than anybody else in the market, and we can continue to push our web site along. So I think we've a lot of me-too businesses out there trying to imitate what we're doing, but they are years and years behind where we are at and we are seeing thousands of customers a month and we are able to continue to evolve that functionality to meet their needs.

On paid search, I think our team has just made some great efforts over the last six months, and like everybody else in the market, we are continuing to evolve paid search from art to science. I think we're just getting really good at it. We've got much more robust analytics behind the scenes and are making some really smart decisions in the way we are approaching that business. So I think that the impact of our efforts in paid search were probably less of an impact on the overall numbers than some of the other things we are talking about, but we're definitely proud of the efforts our team has made in that area. We think they've done really well.

Doug Anmuth - Lehman Brothers

Thank you.

Operator

Our next question comes from Christine Korber - JMP Securities.

Christine Korber - JMP Securities

Looking at your competitive pricing strategy, obviously it worked in Q2. Who do you think you're taking share from? Is it mostly online retailers, or are we looking at offline folks as well?

Then secondly, you talked about good momentum throughout the quarter. Were trends consistent throughout the quarter or did we see an uptick late in the quarter?

Mark Vadon

Sure. On share, we're definitely taking the share from the offline environment. There is really no one online with enough sales for us to take share from. So this is definitely with the pricing, it's more about taking consumers who are relatively nervous with doing a multi-thousand dollar purchase over the Internet and putting enough value on the table and putting enough of a robust consumer experience on the table where they have the confidence to go ahead and make a purchase.

I think, as we get really aggressive in pricing, we hear comments out there from within the industry. We will hear individual retailers who run a single store out in Middle America commenting, either through the trade or within trade business-to-business discussion forums. They will talk about they have customers coming in trying to get them to match a price from Blue Nile, and the price they are asking for is less money than they can buy that product from a wholesaler for.

So just as we get larger, we have so much buying power and then we try to stay really disciplined in our margins. It puts a lot of pressure on the smaller offline retailers, and I think that's where the bulk of the share is coming from.

Diane Irvine

In terms of sales trend, I'd say things look a little different then when we talked to you about our first quarter; that was the quarter in which we had adjusted our diamond pricing. So then there was a very significant upward trend as we moved through the quarter. In this case, prices were lowered well before we came into the quarter, and what we saw was strength across the board throughout the quarter.

Christine Korber - JMP Securities

Great, thank you.

Operator

Our final question comes from Jim Hurley - Telsey Advisory Group.

Jim Hurley - Telsey Advisory Group

Good afternoon and congratulations on a truly spectacular quarter here. I had a question about the high-end transactions. Are you guys doing anything different on the marketing front in terms of targeting a different customer base? How does this number of seven transactions above $100,000 compare to last year?

Mark Vadon

Sure. It's good to hear you again, Jim. Let's see. On the high-end purchases, we're really not doing anything different in the marketing. I think the online environment just naturally appeals to the higher-end, more educated, more affluent consumer base. They are just much more comfortable making this type of purchase on the web because they are more used to technology, they are more used to allowing information to impact the way they purchase.

I think also what's happening over time with the Internet is it is appealing to a wider range of age groups, which a lot of those really high-end purchases, it's not our kind of typical 25 to 35-year-old man buying his first diamond. Those diamonds, a lot of them are upgrade rings happening at significant anniversaries.

So I think part of this is a marketing effort on our part; it is just the maturing of the Internet and the maturing of our reputation and our brand out there.

As far as how this compares to last year, I don't have specific numbers in front of me but it's definitely, we saw the velocity of that type of purchasing was much stronger than I think we had ever seen it before.

Jim Hurley - Telsey Advisory Group

Got it. Then in terms of the higher traffic and conversions, would you attribute the improvement in those metrics, or at least in the conversion rate, to what you're doing on the marketing front, or is it more merchandising when they actually get to the site? Where do you think that benefit is happening?

Diane Irvine

I think, in terms of the conversion, Jim, it's a lot of things we're doing throughout but certainly we feel that those things we're doing in our marketing vehicles are great, but then when you combine that with our pricing strategy, I think that leads to much better conversions.

Truly, the diamond search functionality that we launched in our site is so differentiated and has had a big impact on consumers, so I think we're doing all the right things to increase the conversion.

When you look at our conversion rate, which is relatively low because of our price point compared to other businesses, any incremental improvements we can get there will really drive through to the bottom line, so that's a big focus of ours and will continue to be as we go through the year.

Mark Vadon

One other item on conversion that's helping us is also just better training and better efforts on the operations side within our call center. I think really, when you look at conversion, it's hard for us to point to one thing. For us, so much of conversion, so much of delivering this customer experience is a cross-organizational effort where there is no one item that's a secret to our execution. It's 1,000 different little things we do in order to all add up and make a much better consumer experience.

So I think probably the biggest ones we can point to are pricing efforts and web site innovation, but it has really been a cross-organizational effort to improve the conversion rates.

Jim Hurley - Telsey Advisory Group

Any commentary on Mother's Day and how that trended relative to your expectations, in terms of the volume and mix of sales?

Mark Vadon

Sure. Mother's Day is definitely a smaller holiday for us compared to the Christmas season or Valentine's Day. Really, Christmas is by far is number one, Valentine's Day number two. Mother's Day I think is bigger for other jewelers but for us, we're so engagement-focused that it's relatively small, but we were very happy with our Mother's Day results.

We've done a lot of new product innovation in sterling silver and in colored gemstones, where our assortment, especially in colored gemstones, was relatively weak historically. Those products worked really well at Mother's Day, and we learned some stuff in those products that we think is going to help us a lot as we get into the Christmas season when price points start to fall and the volume starts to move from engagement over towards the other types of jewelry that are out there.

Jim Hurley - Telsey Advisory Group

Perfect, and congratulations again. Really, a fantastic quarter.

Mark Vadon

Thanks, Jim. Thanks, everybody, for joining us and we look forward to talking to you again in a few months. Thanks.

Operator

That concludes today's conference call. You may now disconnect your lines.

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Source: Blue Nile Q2 2006 Earnings Conference Call Transcript (NILE)
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