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Here’s the entire text of the Q&A from Blue Nile’s (ticker: NILE) Q3 2005 conference call. The prepared remarks are here. We recognize that this transcript may contain inaccuracies - if you find any, please post a comment below and we’ll incorporate your corrections. And please note: this conference call transcript is a Seeking Alpha product, so feel free to link to it but reproduction is not permitted without the explicit permission of Seeking Alpha.

Question-and-Answer Session

Operator

Operator Instructions Your first question comes from Dan Geiman from McAdams Wright Ragan.

Q - Dan Geiman

Good afternoon. Mark and Diane, what's your outlook for diamond prices for the rest of this year and also into '06?

A - Mark Vadon

Thanks, Dan. You know, I think there's a little bit of uncertainty around that but our best guess from what we're hearing in the supply chain would be that diamond prices stay pretty stable. I think what people are seeing is retailers being relative cautious with the inventory they're buying. I think retail in general, people are approaching the holiday season cautiously so people aren't buying from the supply chain as soon as they normally would. So based on that we think the prices from wholesalers and cutters will be reasonable as they're holding a good amount of inventory going into the holiday season. As we go into '06, truthfully we don't have a tremendous amount of visibility into that and I think that's largely dependant on how the holiday season turns out for retail.

Q - Dan Geiman

Okay. Thanks.

A - Mark Vadon

Thanks, Dan.

Operator

Your next question comes from Doug Anmuth with Lehman Brothers.

Q - Doug Anmuth

Thank you. Can you talk a little bit about your Cap Ex guidance? Looks like you've lowered it for the last couple quarters. I'm just curious what's driving that lower and is there anything that you're pushing out a little bit in term of investment spending? Thank you.

A - Diane Irvine

Thanks, Doug. Yes, in terms of our Cap Ex, actually we don't have a lot to spend capital expenditures on. We have, you know, there's some timing in there with respect to infrastructure investments, things that we may do next year, some decisions we've made on technology applications, but really just difference in timing compared to the beginning of the year and also not a lot that we need to do in the business.

A - Mark Vadon

Yes, I think at the beginning of the year we were looking at potentially building a new fulfillment center this year, but we made some great improvements to our existing fulfillment center, or our lease on that center comes up next year, but what we're seeing is we can just get more and more productive with what we have, so we haven't had a lot of Cap Ex needs around that. And then on the technology side we've got some great people in development and Web operations and they've been able to build a very scalable set of systems that are handling the traffic we're experiencing quite easily right now.

Q - Doug Anmuth

Okay. Great. Thank you.

Operator

Your next question comes from Dana Gray with JPMorgan.

Q - Dana Gray

Thanks. I had two questions. First about your U.K. site. I was wondering if you could talk a little bit about how you're handling customer service there? I noticed after the launch the customer service number is actually a U.S. telephone number and I'm not sure when or if having a non-U.K. based number will become a gating factor as far as customer service. And then the second question was if you could give us an idea of how the traffic patterns were relative to last quarter. I think last quarter you said that traffic was trending up about 15%. Thanks.

A - Mark Vadon

Sure. On the U.K. site, customer service is right now being handled out of Seattle and I think right now we still have a 206 area code, the Seattle area code number up there. That is an obstacle to that business. We are switching it over right now to a toll-free number coming from the U.K. to Seattle. Right now we're actually just waiting on British Telecom to switch that over and that should be going up shortly. Certainly soon enough for the holiday season. So we'll be making that change. I think eventually we'll need extended time frames in our customer service center or potentially even customer service on the ground somewhere in the EU for that business. In general, that business is scaling really well. I think we said a couple times in the script that it's still a small business, which it is, but we're just seeing really good growth. I think since the launch of the updated site on September 28th, the conversion rates on the site are up about four times and we're quite hopeful about next year. Again, it's still a relatively small number but I think the way to really think about it, we think of the U.S. business as right now being equivalent to about 200 to 240 jewelry stores. You know, if we were a physical chain of stores, that's how many stores we would need on the ground, and our U.K. business is still roughly four stores. So much, much smaller base but we're looking at it and saying, you know, in a very short period of time we built out the equivalent of four stores in the U.K., and that business is obviously seeing growth rates that we haven't seen in the U.S. for since really the first year of business. So we're quite optimistic about how that will scale over time. On traffic patterns we saw roughly the same pattern as in Q2. So it was, you know, roughly 15% increase in traffic and then a 10% or so increase in conversion rate or yield off of that traffic that we were bringing to the Web site. So a similar trajectory on both of those metrics as we have been on.

Q - Dana Gray

Thanks very much.

A - Mark Vadon

Thanks.

Operator

Your next question comes from Pete Spear with Delafield Hambrecht.

Q - Peter Spear

Hi. Good afternoon. I was wondering if you could just discuss in general the other competition online with online jewelers? What you're seeing there, if you're feeling any threat whatsoever from the online space? I know there's a lot of buzz from them as far as how to compete with you being the benchmark for online jewelry. And then I wonder if you had a range for stock option expense costs for next year that you can give?

A - Mark Vadon

Sure. Thanks, Pete. I'll take the competition question and then Diane can talk about options. On competition, frankly, we're just not seeing, we're hearing buzz like you are but we're not seeing much impact of that buzz. I think we've got really not much competition left from kind of a pure-play online jewelers. There's really one other company in that space and they're, say, stumbling along at best right now. Physical store retailers I think are inherently conflicted with going on the Web. They're running in their physical stores at roughly 50% gross margins, if they come online, they either have to come online at full price and for multi-thousand dollar items people comparison shop and it's hard really with 50 gross margin to compete with somebody at 22 or 23 gross margin. So I think they're pretty inherently conflicted there. I think the latest call from Zales, they said that their online business was roughly $18 million in revenue. So, you know, that's, gosh, less than 1% of their revenue's going on over the Internet. And it's not from a lack of trying, I just think the business model, there's so many categories where multi-channel is the appropriate business model. And in the jewelry category the online and offline economics are so different that I think it's tough. I'd say the third category of competition comes from really the online mass merchants. And in that category we're seeing a lot of activity or a lot of effort and I think people might be having some success at much lower price points. I think the equivalent in the offline world is Wal-Mart sells a lot of jewelry, Tiffany sells a lot of jewelry, but people really buy quite different products from them. I think if there's any good news to competition we think really as the mass merchants have more activity around the jewelry space, it's really raising awareness for consumers that they can buy jewelry on the Internet. It's putting jewelry category on the map as a relevant online category, and I think we feel we'll continue to be the dominant player in the space. I think if you look at our revenue that we're putting up every year and the growth dollars, the dollars of growth we're putting up every year, we feel we're just pulling away from anybody else. But the more buzz and the more attention we can get for the category I think the better it is for our business over time.

A - Diane Irvine

And, Pete, with respect to stock option expense, I don't have an amount to give you today, we're still assessing the amount of the stock comp expense under 123R and the actual amount of that expense will be determined based upon future equity grants that are made as well as all of the assumptions that will be used in evaluation model. So our plan would be that on our fourth quarter call we would be giving '06 guidance which will include the stock comp expense under 123R.

Q - Peter Spear

Thanks very much.

Operator

Operator Instructions Your next question comes from Pauline Reader with Thomas Weisel Partners.

Q - Pauline Reader

Hi, just a question on the international. Apart from the U.K. and Japan where the diamond acquisition rate, engagement acquisition rate's pretty high, it seem like to grow the business outside of maybe a few small English-speaking countries it's going to have to done kind of through the non-engagement business? And I'm just wondering since that's not how you've grown the U.S. what kind of issues that might pose for you or how you're going to grow the business when kind of the core, your core isn't as big in other countries?

A - Mark Vadon

Thanks, Pauline. And Pauline, I just saw your report on our U.K. business and I just wanted to tell you I thought that was, I don't usually compliment people on calls on their reports but I thought that was a great report and we actually learned a good amount by reading it ourselves. Thanks for that. On the market side, one thing that just always be cognizant of is the U.S. is just the dominant market for this retail category by far. The U.S. market is roughly 50% of the world market for diamonds. And so we want to, you know, we want to be getting into these other markets kind of to put a flag in the ground and start building them out more as long-term pieces of this business. But I really think what we really need to be executing on very strongly is the U.S. market. So today we still are roughly 3% of the U.S. market for engagement rings, but we're a lot more aggressive on and what we think is a lot more important is getting that 3% to 15% as opposed to trying to build a business in Italy or Germany or Hong Kong or any of those markets. That being said, I think what you're pointing out is actually quite--is quite true. The relevant markets, if you look globally at diamonds, and I think at the end of the day we really define ourselves around that diamond product line. Over time, I think if you go out to say, 2010, you're going to see the jewelry, the non-diamond part of our business, being increasingly important because it has such great growth rate especially as the people who bought in diamonds come back and start buying other products. But really we are defined I think much more by diamonds. So the relevant markets for us, or the most important markets for us, the U.S. by far, second to that would probably be Japan, where we think there is a tremendous opportunity over time. And then the U.K., I think there's also a good opportunity in some other European markets. Maybe what we need to do there is focus more on other diamond products as opposed to so specifically on engagement. But for instance, Italy has a tremendous diamond industry. It's just not quite so focused on engagement. And I think those are all markets where we can build over time and we'll learn more about the potential for them as we get more experienced in the U.K., but once again I think for us the important thing, and I think for everybody watching us, the most important thing in understanding how we're going to do is really focusing on that U.S. market.

Q - Pauline Reader

Okay. When you said 2010, the non-diamond business, did you mean your non-engagement business?

A - Mark Vadon

Yes, that's probably a better--that's more of what I was thinking. The non-engagement business for us as you get out to that period of time it won't be larger than the engagement business, but when you start looking at the economics of that business, because it has higher gross margins, I think our economics will probably be as driven by the non-engagement as the engagement part of business.

Q - Pauline Reader

Okay. Thanks a lot.

Operator

We have time for one more question. From Nat Schindler with Piper Jaffray.

Q - Nat Schindler

Yes, hi, good afternoon. I just have a couple of questions around your marketing spend. One, how much is it of your SG&A? Two, how are you really spending it? And, three, why aren't you spending more? Mostly as I see it, it seems that as you work through your guidance each quarter that to get to your numbers versus what you report, it's usually coming out of that SG&A line and I'm guessing it's coming out of marketing where you're not spending another half a million dollars each quarter and getting to some upside of the quarter, beyond your revenue upside. Is the marketing spend adding a lot to revenue? Is there a good way, is there an opportunity to drive revenue faster through additional marketing? Or is it just not as valuable?

A - Mark Vadon

I think, in general, if you look back at what we said over time, marketing runs roughly 4% of revenue and that's consistent over time as the business has scaled. Some quarters it's a few basis points more, some a few basis points less. But overall it runs 4% of revenue. We spend it almost exclusively online and really stay very focused on the online market. As far as why we don't spend more, I think we like being a profitable business, and when we look at it, what we're really trying to do is optimize operating profit and optimize the long-term operating profit of the business. And we think it's actually when you look at other online businesses out there, in our space or outside of our space, they spend irrationally when it comes to marketing. I think when you look at our business, it's a pretty unique business, more so than others. When you look at what the consumers we're trying to bring in, no matter how much marketing we do, we're not going to convince more people to get engaged. And no matter how effective, how good the marketing is, it's hard really when you look at our price points, it's hard to convince you with a banner ad to spend $5,000 over the Internet. So what works so much better is us just driving an incredible experience, incredible value for our customers. And if we do that, they come back, and then more relevant for us, they tell each other about it and the business just kind of spreads. I think, Frankly, it's kind of amazing that we've built a couple hundred million dollar business when we spend 4% on marketing. We could ramp that up to 10% but I think if we did that you wouldn't see the economics when it works. You wouldn't see a commensurate increase in revenue. And when we look at this business we believe it's not about, you know, ramping the growth up to 80% and maturing the business very quickly, but it's more about letting the business develop, letting consumers get more come favorable at the Internet, letting consumers get more comfortable with spending multi-thousands of dollars over the Internet on a single purchase. And that's happening over time. I think that we're going through more, Blue Nile today is really a business for early adoptors. It's for people who have allowed technology to change their purchasing behaviors at a price point in a category that's incredibly important to them. And what we really have to do is not go out and run television commercials like an Overstock.com, but what we need to do is stay focused on delivering a great experience and let the market mature and let people grow comfortable with the Internet. If we do that, I think you'll see us continue to grow at the rates we're growing now for at least five more years. When you look at the profitability of the business, and how that gets leveraged and gets better each quarter, and when you look at even more importantly the cash flow dynamics of this business, I think we've got a pretty good economic engine on our hands if we keep building this like we are.

Q - Nat Schindler

Okay. Thank you.

A - Mark Vadon

Sure.

Operator

Ladies and gentlemen, thank you for joining today's conference call. This concludes the call. You may now disconnect.

Mark Vadon, Chief Executive Officer

If I'm still on, thanks everyone for joining us and we look forward to talking to you next quarter. Bye.

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