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Blue Nile, Inc. (NASDAQ:NILE)

Q3 2006 Earnings Call

October 30, 2006 5:00 pm ET

Executives

Nancy Shipp - Director, Investor Relations

Diane Irvine - Chief Financial Officer

Mark Vadon - Chief Executive Officer

Analysts

Scott Devitt - Stifel Nicolaus

Jim Friedland - Cowen and Company

Mark Mahaney - Citigroup

Douglas Anmuth - Lehman Brothers

Jack Murphy - William Blair

Kristine Koerber - JMP Securities

Aaron Kessler - Piper Jaffray & Co.

Jim Hurley - Telsey Advisory Group

Presentation

Operator

Good afternoon, ladies and gentlemen. My name is Derek and I will be your host operator on this call. Your lines will be placed on a listen-only mode. At the end of the presentation, management will be available for questions.

(Operator Instructions)

At this time, I would like to introduce Nancy Shipp, Director of Investor Relations of Blue Nile. Please go ahead, Madam.

Nancy Shipp

Good afternoon, and thank you for joining us on our conference call today to review our third quarter 2006 financial results. With me today is 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 for purchase of fixed assets, including internal use software and website development.

We will also discuss non-GAAP net income, which is defined as GAAP net income less FAS-123R, stock-based compensation expense and the related income tax effect.

Lastly, we will discuss non-GAAP SG&A costs, which is defined as GAAP selling, general and administrative expenses, excluding FAS-123R stock-based compensation.

We report these measures to provide an additional tool to evaluate our operating results and financial conditions. Please refer to our website at www.bluenile.com to obtain a copy of our non-GAAP financial measures, which contain a full reconciliation of free cash flow, non-GAAP net income, and non-GAAP SG&A to their nearest respective GAAP financial measures.

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 margins, expenses, net income, operating cash flow, capital investments, and other financial statement 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 that they are made, and are subject to significant risk and uncertainties. Actual results may differ materially and adversely from any projections in 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 important 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.

Now, I would like to introduce Diane Irvine, Chief Financial Officer of Blue Nile.

Diane Irvine

Thank you, Nancy, and good afternoon, everyone. Welcome to our third quarter earnings conference call.

Our third quarter financial results continue to demonstrate our dedicated focus on executing with excellence throughout our business. I am pleased to report that for the third quarter, we delivered strong results in both net sales and earnings. We generated net sales of $53.2 million in the third quarter, up 26.8% from the prior year.

Net income in the third quarter totaled $1.8 million, or $0.11 per diluted share. Our net income included $1.2 million of stock-based compensation expense under FAS-123R, 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 $2.6 million, or $0.16 per diluted share for the quarter, compared to GAAP net income of $2.5 million, or $0.13 per diluted share in the prior year.

Through the effective execution of our strategy, we delivered results beyond the high-end of our Q3 guidance of $52 million for net sales and net income of $0.10 per diluted share. Our performance continues to be driven by the combination of our superior customer experience and our low-cost position.

In Q3, total orders increased 19.4% as compared to a year ago. Our average selling price per order was $1,884 in the third quarter, compared to $1,773 a year ago, representing a year-over-year increase of 6.3%.

Sales growth was strong across all of our product categories during the quarter, and ticket sizes have risen in nearly all product categories outside of engagement, while our engagement ticket size has remained constant.

I would 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 our international sales are still relatively small, we have seen tremendous growth.

In the third quarter, we generated approximately $2.2 million in net sales through our Canada and U.K. websites. This represents 259% 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.

Let’s review some of the key drivers behind our third quarter results. First, revenue growth remained strong during Q3, particularly in our core product offering. Our aggressive diamond pricing strategy helped to drive our top-line growth. Our objective within our business is to maximize dollar profit growth and free cash flow, and our pricing strategy is key to the way we manage the balance between sales growth and earnings.

We believe our diamond pricing strategy was very effective in generating profitable growth in the third quarter. From a longer-term perspective, we believe that our competitive pricing is an important element in building our business and gaining market share. As a seven-year old business that is in the early stages of redefining the way consumers purchase diamonds and fine jewelry, our business is very much about acquiring new customers and capturing market share in a competitive marketplace. Our pricing strategy is a key competitive advantage in this context.

In marketing, while the costs to acquire new customers continues to rise as a result of the online marketing environment, our investments in key marketing initiatives are generating positive results and contributed to our Q3 performance.

Within each of our marketing vehicles, our focus is to generate a profitable return on our investment. We have maintained this disciplined approach with the rising cost of online marketing.

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.

During the third quarter, we increased the amount of traffic to our website, as well as our conversion rate. We experienced strong growth in repeat and referral revenue during the third quarter, at rates in excess of our overall Q3 top-line growth. We believe this is evidence that the details we focus on in our customer experience make a big difference.

In addition, for the second straight quarter, our top geographic markets in terms of per capita spending, which includes the San Francisco Bay area, Washington, D.C., and Boston, grew faster than the other domestic markets in Q3.

While the rest of the country continues to follow a strong growth trajectory, we believe that our ability to continue to increase penetration in our most established markets demonstrates the strength and potential of our business.

In our most developed geographic markets, our penetration is more than three times our national average, and growing rapidly. We believe this points to the potential of our business over the long term.

We continue to focus on perfecting the execution of our customer experience. During the third quarter, we continued 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 capabilities.

We believe that this excessive focus on the customer is what will continue to help us grow market share.

We focus relentlessly on the basics -- the many details that make up the Blue Nile customer experience, and 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. From the quality of our products and our compelling value proposition to our expert customer service and our industry leading shipping times, we focus on creating a perfect customer experience.

We also focus with relentless attention on continuously making our website even more engaging for our customers.

I will now move on to review more of the financial details included in our third quarter results.

Gross profit for the quarter was $10.4 million compared to $9.2 million in the third quarter of 2005, an increase of 12.8% year over year.

Gross margin for the quarter was 19.6%, compared to 22% a 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 cost increases for gold, silver, and platinum jewelry that we incurred earlier in the year, but did not fully pass on to consumers in the third quarter of 2006.

Our Q3 results reflect our keen focus on execution throughout the business. We performed well in managing through a challenging cost-input environment to deliver outstanding results. We continued to realize economies of scale in our SG&A costs. Overall, our non-GAAP SG&A costs grew 17.4% year over year in the third quarter, while supporting sales growth of 26.8%.

In Q3, we successfully completed the implementation of the upgrade of our Oracle financial system. Even with additional costs related to the Oracle upgrade, we performed very efficiently overall on the cost side in Q3. We performed at a high level for our customers, and executed diligently on our fundamental business drivers.

Interest income was $670,000 for the quarter, compared to $663,000 in last year’s third quarter. Our effective tax rate for financial reporting purposes, was 35.6% in Q3 2006.

Looking at our cash flow statement, I would like to review our cash generation results. On a trailing 12-month basis, non-GAAP free cash flow grew 22.7% to $28.3 million, compared to $23.1 million for the trailing 12-month period ended October 2, 2005.

Net cash provided by operating activities increased 21.7% to $30.3 million for the trailing 12 months, compared to $24.9 million for the trailing 12-month period ended October 2, 2005.

I want to point out that during Q3, Blue Nile fully utilized its net operating loss carry-forwards for federal income tax purposes.

With respect to the favorable working capital dynamics inherent in our business model, we have achieved significant improvements in working capital management over the past year. We believe there is a lot of opportunity to continue to drive working capital benefits in our business, and this will be a key focus as the business continues to scale.

I would also like to provide an update on our share repurchase program. During the third quarter, we repurchased approximately 239,000 shares, or 1.5% of shares outstanding, for an aggregate purchase price of $7.8 million. After these share repurchases, we ended the quarter with $53.9 million in cash and marketable securities.

I want to point out that our share repurchases during Q3 were neutral to earnings per share, although they will be accretive to earnings over the long-term.

Since the inception of our share repurchase program in February, 2005 through the end of September, 2006, we have retired approximately 12.7% of the outstanding shares of the company, for a total purchase price of $71.6 million, which represents an average price per share of $31.67.

Q3 was the eighth consecutive quarter in which we reduced diluted shares outstanding. As of today, $96.4 million remains to be spent under the $150 million in stock repurchase programs that have been authorized by our board of directors. 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.

Looking ahead, I would like to review our financial guidance for the full year 2006. Based upon our Q3 and year-to-date performance, we are raising our financial guidance for the full year 2006. We expect net sales for the year to be between $249 million and $255 million. This range is an increase from our previous guidance for 2006 net sales of $240 million to $252 million.

We expect net income per diluted share to be between $0.70 and $0.75 for 2006, up from our previous EPS range of $0.67 to $0.74.

The estimated net income per diluted share includes the estimated impact of expensing stock options under FAS-123R of approximately $0.16 to $0.17 per diluted share. Actual stock-based compensation expense for the fourth 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 million to $2.2 million.

The effective tax rate for financial statement purposes for the fourth quarter is expected to be approximately 35.5%.

In summary, we are pleased with our strong Q3 results. We have managed well through a challenging cost input environment, during which we have met and exceeded our revenue and EPS guidance for the first three quarters of the year. We remain confident in the strength of our business and our ability to consistently deliver on our financial target.

I will now turn the call over to Mark.

Mark Vadon

Thanks, Dianne. Blue Nile began in 1999, and in our first year, we posted revenue of $14 million. As a new company, that felt like tremendous growth, but it was really just the beginning of a phenomenal growth trend that continues to this day, and which I believe will continue for many, many years to come.

With hard work and an unwavering focus on providing our customers with the best offering in the fine jewelry market, we have grown our customer base and revenue every single year.

In 2006, our eighth year in business, we believe we will surpass $0.25 billion in revenue.

By any measure, that is tremendous progress. I have always been extremely proud that while we have achieved phenomenal revenue growth, it has not come at the expense of profitability.

We became profitable on an EBITDA basis in August of 2001, 27 months after our founding. Since that point, we have grown EBITDA and free cash flow every year.

When we began our business in 1999, one of the first things we did was field a consumer study to help us understand how people thought about purchasing engagement rings and fine jewelry. The results of that study dictated the fundamental design of our business model and our brand.

In that study, we asked consumers what factors were most important when they chose a retailer of fine jewelry. We gave them 21 different factors to rate, and when the results came back, the top factors rated by consumers were, in order:

  • Good value for the money;
  • Knowledgeable salesperson; and
  • The salesperson does not pressure me.

Interestingly, consumers said the lowest ranking factor out of all 21 was “I am able to closely examine the diamonds and jewelry.”

As we designed our business, we methodically tried to make sure Blue Nile would perform extremely well on all of the most important purchasing measures for consumers. We did this well out of the gates and our performance has only gotten better over time.

In the study, consumers told us they wanted value, and we listened. We priced some 30% lower than a normal physical retailer of jewelry. In the first eight years of our business, we believe we have saved our consumers over $500 million compared to what they would have spent if they shopped at a typical jewelry store.

Consumers told us they wanted knowledgeable sales people. To meet this need, we put our customer service team through extensive training before they ever interact with customers. That said, their best training comes on the job.

Statistically, a typical sales person in a jewelry store will sell approximately a dozen engagement rings per year. In comparison, a customer service agent at Blue Nile typically sells over 1,000 engagement rings per year. To put it another way, a typical jewelry store sales person would have to work for over 83 years to get the same experience a Blue Nile agent receives in just one year. The knowledge of our customer service team cannot be matched by stores.

Customers told us they hated high pressure sales. Do you know why they feel that type of pressure when they shop for fine jewelry? It is because most people selling jewelry work on commission, and we all know what it feels like trying to buy from a commission sales person.

At Blue Nile, you will not be pressured. Customers who choose not to speak with a customer service agent are empowered to make an educated decision solely through interaction with the website. Many customers choose to purchase in this way. For those customers who do speak with a customer service agent, they are speaking with somebody who makes no commissions and who sees their job as trying to assist a customer in this once-in-a-lifetime experience.

We have made the conscious choice to never pay commissions, and we think it has resulted in a far superior consumer experience.

As you run down the list of what consumers look for in a jeweler, what you will find is that Blue Nile provides a better shopping experience. We intend to only get better.

Many retailers fundamentally believe that there is a trade-off between service and costs. They feel that if they are going to ramp up the service they provide to customers, they are not going to be able to remain low-cost.

At Blue Nile, we believe we can accomplish both. I just told you about the strength of our consumer experience, but our real strength is that we deliver this experience while maintaining a cost structure that traditional jewelers cannot match. While our competitors typically maintain SG&A levels of 40% plus, we have trailing 12 months SG&A before 123R stock compensation of just 12.7%, and we intend to drive that number down even further. For other jewelers, Blue Nile is an extremely difficult company to compete against.

Consumers have been recognizing the power of our business for the last eight years, but increasingly, the model is also being recognized by respected business media. Earlier this month, Forbes ranked Blue Nile number 18 on its list of the 200 best small companies. Forbes describes this as a list of the most robust, fundamentally disciplined public companies with sales below $750 million.

In addition, Blue Nile was ranked number 10 on BusinessWeek’s list of America’s 100-fastest growing small companies. BusinessWeek describes the companies on this list as strong, agile, and fiercely competitive.

We are honored by our inclusion on both of these lists. We are also very proud to have recently been given the BizRate Circle of Excellence Platinum Award. This award recognizes the very best online retailers in customer satisfaction, as judged by previous online buyers from those retailers. This marks the fifth consecutive time Blue Nile has received this prestigious award. We consider this award one of the highest honors we can receive, as it is based solely on the experience and satisfaction of our customers, not a subjective third party evaluation.

By delivering an unmatched buying experience and tremendous product quality, we believe we are very early in the process of building an enduring consumer brand.

As we gear up for the holidays, we feel great about our competitive position. Our constant desire to provide an unmatched customer experience is the essence of building a long-term brand. We are about building our business for the long term, and this takes discipline on all fronts -- financially and operationally.

Gaining the trust of the customer is the best source of advertising that we have. To give you a sense for how much consumers trust Blue Nile, I would point to an engagement ring we sold in October for $324,000. I have often told investors about the amazing high-end orders we receive, but this one was truly special.

On the merchandising front, we are extremely well-positioned for Q4. We have new offerings geared toward the holiday that include beautiful sterling silver and pearl items, all the way up to one-of-a-kind diamond jewelry products. Our product assortment, while being carefully edited by our merchant to provide a distinct viewpoint, is the largest and deepest assortment in the company’s history.

We are confident that our customers will enthusiastically embrace our product offerings this holiday season.

In closing, I want to thank our investors and analysts for participating on today’s call. As we reflect on our third quarter results, we are proud of the success we have achieved, thanks to the way in which our employees establish a standard of excellence for the Blue Nile brand.

As the holiday season approaches, we are laser-focused on providing an exceptional experience for our customers and building upon our industry-leading position in online diamond and jewelry retailing.

I truly believe that this is just the beginning for Blue Nile. I believe we are well-positioned to generate profitable growth into the future and I believe our business has the ability to capture significant opportunities in the years ahead.

This is the end of our formal presentation, and 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)

Your first question comes from the line of Scott Devitt with Stifel Nicolaus.

Scott Devitt - Stifel Nicolaus

Thank you. I just had one question, and it is more global in nature, I suppose, than specifically related to the quarter. You have done a great job the last two quarters and really going back into March of this year of reaccelerating the top line, and that has significant benefits in getting the company scale on a fixed G&A on a long-term basis. I guess the first part of my question is, is 10% still the number that you are talking about long-term in terms of operating expenses as a percentage of revenue?

Then, more specifically, you will annualize this pricing leverage I believe in March of next year, so how should we look at that going forward? Do you think you are going to be pulling that lever again into 2007, or will the gross margins begin to stabilize? Thank you.

Diane Irvine

Thank you. In terms of our long-term goal for operating expense as a percentage of revenue, you are absolutely right. We still have that 10% goal. We have seen great leverage in the business, so we feel like we can get there.

In terms of the pricing decisions we make, the way we think about the business is really maximizing profitability and cash flow, and so we make decisions from time to time based on the environment. We will always pull the levers that we think are proper at the time. I think that is what we will continue to do, and work to maximize the profitability.

Mark Vadon

I think our decisions around pricing over the last six months to a year have really been driven by what is happening in the online marketing environment. I think if you look at the data that is out there, from different sources, for the last couple of years, at least, online advertising in the U.S., spending on online advertising for the industry has been growing 35% plus, and meanwhile the number of people in the U.S. who are on the Internet has been growing in the single digits. Effectively, to catch the attention of consumers, it is becoming more and more expensive. I think our mindset has been, in that type of environment, we would rather put the money into lower prices for our consumers rather than trying to raise above the noise.

I think over time, as we go forward, what we are really looking at is how do we build this business out over the next 20 years, not quarter by quarter, what is the way to build the business.

I think each quarter, we will look at the environment and make the appropriate decisions to keep scaling the business and keep scaling the profitability along with it.

Scott Devitt - Stifel Nicolaus

If I could just follow-up, within the SG&A line -- you may have stated this, and if so, I missed it, I apologize -- is the ad spend still 4% of revenue? Has that maintained consistency? Then, on top of that, the consulting costs within the SG&A line, how has that trended this year versus last, with the Sarb-Ox changes, in terms of what you had to spend to actually launch that program?

Diane Irvine

In terms of marketing, yes, it has been relatively constant at about 4% of revenue, and that is when you look at all of our marketing vehicles, kind of where they blend together.

In terms of our Sarbanes cost, we are slightly less this year for Sarbanes specifically, but if you look at public company costs, we are roughly 1% of revenues. It is pretty steady with last year in terms of the total dollars.

Operator

Your next question comes from the line of Jim Friedland with Cowen and Company.

Jim Friedland - Cowen and Company

Thank you. A question on average order value. The last quarter, there was big AOV growth and then, if you look back last year in Q3, AOV growth was flat year over year, and this year, it was up a little bit. Also, last quarter, you mentioned a number of higher AOV orders in the mix. I think there were six orders over 100K. Could you talk about how that has actually changed in the quarter? Then also, have you lowered pricing beyond the pricing drop that occurred in March? Basically I am asking, has this been an on ongoing thing, or was it really just one big price drop in March and nothing since?

Diane Irvine

Thanks, Jim. In terms of average order value, every day we have significant five-digit transactions, and certainly every quarter, numerous six-digit transactions. I think we might have had a couple more in the second quarter, but really what is driving the average ticket, and if you look at the increase year over year in the third quarter, I think pretty much as I mentioned, all of our pricing has come up. A part of that is certainly driven by the aggressive diamond pricing, where even if you look at non-engagement diamond jewelry, that is doing very, very well with great growth as well as ticket size increasing.

Then, in terms of our pricing moves, the major change structurally that we made was in about the middle of the first quarter. We do continue to adjust categories of diamonds based upon supply demand dynamics, but that structural change really was kind of one-time this year.

Jim Friedland - Cowen and Company

Okay, and just one other quick one. The growth in orders has been accelerating every quarter this year, and you said that both volume growth to the site and conversion rates have improved. Is the waiting on improved conversion rate or is it more just more people coming to the site?

Diane Irvine

If you look at growth through the quarter, really it is more in conversion, the growth in conversion is greater. We are continuing to work on our website really to make it user-friendly, get customers through, and especially in times when it is more expensive to acquire new customers. We are increasing traffic to the site, but we really need to focus on conversion in those times, because that is what really will lead to better profitability. So it was a blend, but it was more driven by conversion.

Mark Vadon

On conversion, we had some great improvements to the website earlier in this year. I think that continued through the summer, and then just about a week or two ago, we launched an updated version to our diamond search, which is really just, if you look at it, we are giving the consumers the ability to rate individual diamonds as they are going through their shopping process. What you are seeing there is really just the first effort in a longer effort to try to tap into the shopping base we have on the site. The community that is jointly shopping there, we are trying to tap into their purchasing knowledge and their efforts to look through those thousands of diamonds, and then take the information from that and bring it back and show consumers what other people are shopping for and what they think of the products that are out there.

There are some great things happening on the site and also in the product assortment. I think we are doing a great job at lower price points, to try to find items that really meet the needs of our customers, and I think that is leading to some really strong conversion trends.

Operator

Your next question comes from the line of Mark Mahaney with Citigroup.

Mark Mahaney - Citigroup

Thank you very much. Two questions, please. First, in terms of international expansion efforts next year, any way we should think about how you want to run the margins of the business, whether that is the free cash flow margin or the EBITDA margin, relative to that international expansion?

In other words, do you want to expand and grow those international markets materially next year within the range of the current margins that you have or in the range of expanding margins? Should we expect that to have a material negative impact on margins?

Secondly, any color or comments on what you are seeing in terms of keyword search pricing already in the December quarter? Thank you very much.

Diane Irvine

Thanks, Mark. In terms of international, I would say as we get into next year, more will be known. We certainly over the long term have opportunities to have better margins there, because there is even a greater value proposition for consumers, for example, in the U.K. where mark-ups in retail are much higher than they are here in the U.S.

I think as we start out, our mindset will be more one of let’s grow the business. We will be looking at it for break-even. We will think that is great.

I do not think you will see a significant impact on margins overall because it is still relatively small, but it will be increasingly a focus of ours as we move into 2007.

In terms of keywords, I would say generally that environment is we are still seeing inflation there, so price is still moving up, but I think we are managing very well there and are really doing some great things and feel really well-positioned as we enter the holiday season in terms of search.

Operator

Your next question comes from the line of Douglas Anmuth with Lehman Brothers.

Douglas Anmuth - Lehman Brothers

Thank you. I just wanted to ask what you are seeing in terms of large-sized stones in terms of consumer demand and in terms of whether you are being as aggressive with pricing on those larger carat sizes. Thank you.

Mark Vadon

I think we are seeing the market being really, really active, at least for us, in larger diamonds. We talked about that on our Q2 earnings call. We saw that throughout Q3 and as we start Q4 here, we kicked off Q4 with the largest purchase in the history of the company. I think at the very high price points, it is either the market is very healthy or we are continuing to get a disproportionate amount of that market. I tend to think it is probably the latter rather than the former here.

I think in general, as the business grows and as we get more awareness out there, our extreme high-end is just going to get stronger and stronger, because the value proposition in that type of merchandise is tremendous. Literally, we are one of the biggest buyers of diamonds in the world, so we buy at very low cost and we are running -- when you look at $100,000 plus diamond, we are running on single-digit margins, high-single-digit margins, so stores just cannot compete. Even if they want to compete with us on that type of product, they literally in many cases have to pay more for the diamond than we are willing to sell to the consumer for.

I think over time, as people build up trust in us and as more people on Wall Street listen to these conference calls and hear me say exactly what I just said, we should do incredibly well in the highest end of the market.

Operator

Your next question comes from the line of Jack Murphy with William Blair.

Jack Murphy - William Blair

Two-part question. First, could you just characterize the competitive response you have seen in the marketplace from the lower diamond prices beginning in the first quarter? Then, related to that, if you fast-forward to the second quarter, could you help us to understand why you might not have to have a deeper investment in gross margin to sustain the growth that you have enjoyed so far, after the investment in gross? Thank you.

Diane Irvine

In terms of competitive response from our lower prices, I would say our competition tends to be the offline retail jewelers, and as Mark has talked about in terms of our price differential through offline, it is so significant that our changes cannot be matched or beaten offline. I think that is why this has only helped our competitive positioning and helped us gain market share.

Then, if you look online, we really are the market in terms of diamonds. It is hard to find the next competitors, so while we are not necessarily the lowest price online retailer, we are doing the bulk of the market share there in engagement and diamond jewelry, so I think it has only strengthened our competitive position, I would say, in terms of the pricing.

As to what happens as we get into next year, I think we will pull the levers in the business that we think are right at the time. As we have gone through in the past couple of years an online marketing environment where prices have risen and it is very, very costly to acquire new customers. This is one of our reactions, but I think we will always make the decisions that will maximize our profitability. I think we will address the environment as we see it at the time.

Mark Vadon

I think just echoing a little bit of what Diane said, on the competitive response to lower prices, really, our two biggest -- I think the quick answer is across the board, we have not seen much in terms of people changing their prices online as we have adjusted ours, but to a large degree, there is not much competition online anymore.

I think our two biggest online competitors, if you looked at it a year ago, one of them was -- I will not put their names out there, but one of them was a public company playing in this space, and they sold off all of their diamond-related assets, and the new owners of those assets are managing them a lot more prudently, so a smaller business than was there before. The other competitor was a company that four years ago had $10 million to $15 million in revenue and today is doing $3 million to $4 million.

I think what we have seen overall is a lot of our competition folding, which is, as we have gone through this environment, which we think the last year and two years has been a relatively difficult environment for merchants on the web.

I think in that environment, we have held up pretty well, while other people are falling away.

Then, on the changes to pricing and how that will be once we anniversary it, I think throughout this year, we have been very, very focused on conversion. Those improvements we have in conversion are helping us this year and they will continue to help us forever in the business, so I think what we are trying to do is to methodically go through the business and improve conversion rates, and hopefully that, along with increasing our expertise and our knowledge in online marketing, will help us to continue to grow the business, as we anniversary the changes that we went through.

As Dianne said, really the goal is to read the business in any given quarter and make the right decisions to maximize the business.

Operator

Your next question comes from the line of Kristine Koerber with JMP Securities.

Kristine Koerber - JMP Securities

Hi, this is Jennifer filling in for Kristine. Quick question -- with regard to growing the international business, are you looking to just penetrate deeper in your current U.K. and Canada markets, or potentially expand into new markets?

Diane Irvine

I think if you look at next year, certainly Canada and the U.K. would be kind of the foundation of that. Ultimately we would like to be in more countries in the E.U. If you look at diamond jewelry, obviously Japan is a great market, but we think that is certainly longer term for us.

We are always mindful that the U.S. is the majority of the diamond market on a retail basis. This is a real opportunity. When we think about growing market share, this is our original focus and this is where we continue to gain market share and where we will grow over the long term, but we do think those international opportunities are great additions to the business, and so we will focus there, but they will still be relatively smaller as you compare even to the potential of what the U.S. business is for us.

Operator

Your next question comes from the line of Aaron Kessler with Piper Jaffray.

Aaron Kessler - Piper Jaffray & Co.

First, as you talk about, how do you close the gap from some of your west coast sites, like Seattle and San Francisco? I think you are probably close to double-digit market share versus the rest of the country over time. How do you increase that share?

Second, could you give us a sense for what the traffic growth was? I think last quarter you said mid- to high-single digits. As you improve the conversion rates, at some point do you look to reaccelerate that traffic growth? Thank you.

Mark Vadon

Thanks, Aaron. On the different markets, I think really what is happening over time, it is just a steady progress of people getting more comfortable with the Internet and doing more over the Internet. That is what is changing in these markets over time.

Historically, if you look a few years ago at San Francisco, we were doing maybe $1 per capita in that market. Today, we are over $2 per capita in that market. It has steadily grown.

Meanwhile, in some smaller markets, typically further away from the coast, people who are not as comfortable with the Internet, in those types of markets, we years ago would have been doing $0.10 per capita, and today it might be $0.30 per capita.

As we look at it, we think eventually, the entire country is going to be comfortable with e-commerce, and comfortable to the extent where they are willing to do things like transact for a multi-thousand dollar product over the web. But it is just going to take more time for some of the country to get there than in markets where really people let technology alter how they are living.

It is not necessarily that we are doing anything differently in those markets. It is just allowing the markets to mature over time.

On traffic trends, in Q3, we saw pretty similar stuff to Q2, so I think you are seeing a continuation of that same trend. I think what is happening a little bit is traffic has not been growing as fast because there are some deals in marketing that we let go and decided not to continue doing as the price of them rose. I think as we begin to anniversary some of those changes in marketing, you may see our traffic growing faster over time than it has been the last couple of quarters.

We are really making the decision on what to invest in on the marketing front on a deal-by-deal level, so it really matters which deals we renew over time and which ones we do not. I think the general trend should be for faster traffic growth, as you look out a few quarters into the future.

Operator

Your final question comes from the line of Jim Hurley with Telsey Advisory Group.

Jim Hurley - Telsey Advisory Group

Good afternoon, congratulations on a good quarter, and especially on all those nice accolades from the press and from your customers, most importantly.

My question is on the advertising spend, and especially relative to the most mature markets, where you are seeing very nice growth. Are you approaching your mature markets differently than the smaller markets that you are hoping to grow into tier-one markets? Is there disproportionate investment in those smaller markets? Or are you really focused on the San Francisco’s and D.C.’s of the world?

Diane Irvine

Thanks, Jim. In terms of our spending, really we look at the country as a whole, and we are not disproportionately spending in those markets. From time to time, there is a little bit of testing that we do. We have talked about over the longer term as those markets continue to grow, those most established markets, maybe there is a little bit more we can do, but we are still pretty soon across the country. So much of what happens in those markets also happen on a referral basis, where that is still our number one source of customers. That is very, very powerful when we get into those markets where so many more people know about us.

We have not directed our marketing spend in that way, but over the longer term, I think that is a possibility.

Mark Vadon

I think in general, when we look at those strongest -- typically, over time what we have experienced is our strongest markets grow slightly slower than the business as a whole. They are slowly -- they get harder to grow as they get larger, but over the last couple of quarters, our best markets have grown the best. We look at it and to be honest with you, we do not fully understand why that is happening, because we do nothing differently in those markets than we do overall.

Our best guess is either those markets react differently to the aggressive pricing. They are more able to see that value proposition there, or I think there is some argument that in those markets, we are hitting some sort of critical mass. If you look in markets where we are weaker, if you are looking at buying from Blue Nile, you might never have heard of us before. You know nobody who has bought from us, and really it takes a little bit of a leap of faith to be the first one to try something like this. Then, as you get to markets that are slightly more penetrated, you may know one person who bought from us.

I think if you go to San Francisco and you start talking to younger men who are looking to get engaged, they probably have multiple friends who have shopped from and possibly bought from Blue Nile, so in those types of situations where it is not just -- you know, we are moving from being a company no one has heard of to a company that you may have heard of to a company that is well-known among your co-workers or your friends.

I think over time, there is an argument that says in those markets, we hit a sort of -- this word is over-used, but sort of a tipping point where there is kind of mass acceptance of the business as a way to shop for this type of product.

Hopefully that is part of what we are seeing there and that continues over time.

Jim Hurley - Telsey Advisory Group

Is there any difference in terms of the product that customers are interested in in some of those emerging markets? Is still primarily engagement jewellery? Or is there a mix, given how high your traffic is among women now, and you are at a different stage of the merchandise assortment?

Mark Vadon

I think what you see in the more mature markets, you see slightly more of the non-engagement items. Because we have a larger base of customers there, there is obviously higher repeat purchasing happening, and the repeat purchasing skews towards the non-engagement product lines. The product line in our best markets is slightly richer in the non-engagement, which lends it to be slightly higher gross margin than overall.

You also just see, as you would see in any luxury business, you see different fashion trends on the coasts than you do in the middle of the country. Really, that is, in most cases, the coastal markets are really strong markets versus the interior, so you know those coastal markets are a little more adventurous in what they are buying, as far as the shapes of diamonds and things like that versus middle America.

Nancy Shipp

Thank you everyone for joining us today. We will look forward to reporting to you on our fourth quarter early next year. Thank you.

Operator

This concludes this evening’s conference call. You may now disconnect.

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Source: Blue Nile Q3 2006 Earnings Call Transcript
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