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Blue Nile Inc. (NILE)

Q4 2005 Earnings Conference Call

February 7th 2006, 5:00 PM.

Executives:

Nancy Shipp, Investor Relations Director

Diane Irvine, Chief Financial Officer

Mark Vadon, Chief Executive Officer

Analysts:

Mark Friedman, Merrill Lynch

Pauline Reader, Thomas Weisel Partners

Dan Geiman, McAdams Wright Ragen

Scott Devitt, Stifel Nicolaus

Imran Khan, JP Morgan

Jordan Rohan, RBC

Operator

Good afternoon, ladies and gentlemen. My name is Christy, 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. If you have a question, please press '*' '1' on your telephone, and you will be placed in the question-and-answer queue. At this time, I would like to introduce Nancy Shipp, Director of Investor Relations of Blue Nile.

Nancy Shipp, Investor Relations, Director

Good afternoon, and thank you for joining us on our conference call today to review the fourth-quarter and full-year 2005 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 free cash flow which is defined as net cash provided by operating activities or operating cash flow, less capital expenditures including internal use software and website development. We report this measure to provide additional tools to evaluate our operating results and financial condition. Please refer to our website at www.bluenile.com to obtain a copy of our press release, which contains a full reconciliation of free cash flow to 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, including expectations of net sales, gross margins, expenses, net income, operating cash flow, capital investment and other financial statement 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 on assumptions that are believed to be reasonable at the time they are made, and are subject to significant risks and uncertainties. Actual results may differ materially and adversely from any projections and forward-looking statements given by management. Our quarterly reports on Form 10-Q, our Annual Report 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 Mark Vadon, Chief Executive Officer of Blue Nile.

Mark Vadon, Chief Executive Officer

Thank you, Nancy. Good afternoon everyone, and thank you for joining us today. I would like to start the call by recapping our fourth quarter and the full year 2005 and discussing our business priorities for 2006. During the fourth quarter, we continued to demonstrate our ability to deliver strong profitability despite a challenging sales environment in jewelry retail. For the quarter, we achieved net sales of $73.2 million, up 13.5% from the prior year, and net income growth of 15.9% to $5.3 million.

Earnings per diluted share totaled $0.29, and were up 20.8% from the same period a year ago. We focused on balanced profitability during the quarter, and in the process we delivered to our earnings guidance. At the end of the quarter, cash and marketable securities totaled $114.8 million. These results add to our history of growth and consistent profitability. Our fourth-quarter results capped off a great year for Blue Nile strategically, operationally and financially. In 2005, we strengthened our competitive position as the leader in online diamond and jewelry retailing, and enhanced our exclusive supply chain relationships. For the full year, our revenue totaled $203.2 million, an increase of 20% over 2004. Earnings per diluted share for the full year were $0.71. Free cash flow for the year totaled $30.2 million.

These results underscore the way in which we are capitalizing on the unique elements of our business model to achieve profitable growth for our shareholders. We offer a compelling value proposition to our customers while utilizing a unique exclusive supply solution and maintaining an efficient cost structure. With minimal capital investment required for growth, this leads to the ability to generate strong cash flow, as evidenced in our 2005 results. We create great customer value and solid growth and profitability, and we remain focused on all three of those measures. We have an exceptional team that is executing a better business model and has driven our success in becoming the leading online diamond and jewelry retailer with revenues of over $200 million, just a little over six years after the initiation of the business.

I would like to give some color on sales trends during Q4. We started the quarter well and had an excellent November with sales growth beyond expectations. During December, we experienced three weeks of sales that were below our expectations. We believe there were two main contributors to our slow December sales. First, the jewelry industry at large performed poorly this holiday season. According to SpendingPulse, a retail sales data provider for MasterCard, jewelry sales this holiday season were down 4.6% from the holiday season of 2004.

Second, during December, we saw extremely aggressive increases in the cost of online advertising. Our cost per click on Google, for example, rose by over 50% from a year earlier. While the cost of online marketing grew significantly in Q4, we remain disciplined in our spending in order to maintain profitability on new customers rather than to chase unprofitable growth, as some of our competitors have done.

Our marketing efforts during the fourth quarter were skewed toward search engine advertising. Given our experience over the past few years with paid search, this seemed like a prudent decision entering the quarter. However, with increased costs for paid search in Q4, we were unable to drive as much profitable traffic as we would have expected. Given these results, we will be looking to broaden our marketing efforts beyond search in the future. As we seek alternative marketing vehicles to complement our efforts in paid search, I would expect growth to be relatively conservative as we ramp our efforts toward broadening our marketing outreach. This is the right long-term solution for our business.

As I've stated before, throughout all of our marketing efforts, our focus is on the maximization of gross profit contribution, in keeping with our overarching objective of free cash flow generation. For the quarter, repeat and referral sales showed excellent growth, which is a strong testament to the value of our efforts in continuing to obsess over the customer experience. This also points to our ability to monetize customers following acquisition.

Turning to the operation side of the business, customer service performed extremely well during Q4, delivering an excellent customer experience while simultaneously driving down unit cost. Our customer service group improved its cost per order by 13% from the fourth quarter a year ago, while continuing to deliver industry-leading performance by answering 82% of calls to our call center in ten seconds or less. Our fulfillment operation maintained an astounding on-time shipping rate of 99.87% of all orders. We achieved this level of performance with shipping timeframes that are among the most aggressive in all of e-commerce.

I'd like to provide an update on our share repurchase program. During the fourth quarter, we repurchased 103,000 shares for an aggregate purchase price of $3.4 million. From the start of our share repurchase program in February of 2005 through the end of Q4, we have retired approximately 3.3% of the outstanding shares of the Company for a total purchase price of $17.4 million. Since Q3 of 2004, we have reduced the number of diluted shares outstanding every single quarter.

We announced today that our Board of Directors has authorized a share repurchase program of up to $100 million over the next 24 months. We believe tremendously in our business and in the strength of our business model. As you know, one of the most attractive characteristics of our business model is our ability to generate strong cash flow. The demonstrated success of our business model provides us with a strong balance sheet, as well as financial flexibility. This repurchase program is in keeping with our stated intention to maximize free cash flow per share overtime, and underscores our commitment to enhancing value for our shareholders.

I would now like to discuss our priorities for 2006. First, we will continue to do what we do best, that is, to expand our core domestic business with exceptional execution. In 2005, Blue Nile reached an approximate 3.0% market share of the estimated $4.7 billion US engagement ring market. Obviously, there is tremendous room for growth in this market.

We will also continue to focus on growing our non-engagement jewelry business. Our non-engagement business showed robust year-on-year growth in 2005, partly due to very strong increases in repeat purchasing from prior Blue Nile customers. We have enormous growth potential in this area of the business as well. International growth will remain a priority in 2006. While the US market remains the main growth engine of our business, we have begun to develop a presence in international markets, specifically in Canada and the UK. We believe that our value proposition to consumers is even more compelling in the UK market than it is in the US.

At the beginning of the fourth quarter, we introduced customization tools for diamond jewelry on our UK website, providing customers with the ability to choose from more than 60,000 loose diamonds and customize their diamond jewelry products such as engagement rings, earrings and pendants. And this offering clearly resonated with UK customers during the fourth quarter. We are particularly encouraged by the early success and development potential of the UK business. For the year, we generated approximately $3.3 million in net sales through our international websites. While this is still a modest base of sales, it represents over 370% growth from 2004 levels.

In 2006, we will continue to obsess about the many details across our business that define the Blue Nile customer experience, and to execute with excellence throughout our operations. Perhaps most importantly, we will also continue to invest in our people. We will focus on attracting and retaining the right team of people as we build our business for the long-term. I believe we are still very early in the process of developing a dominant brand in the retail jewelry category. With exclusive Internet rights to a vast selection of diamonds, the most efficient cost structure in the jewelry retailing industry and a growing base of customers who are ecstatic with their Blue Nile experience, we are positioned for long-term success. As a business, we are growing and financially healthy, and we will continue to strive for annual growth and free cash flow and free cash flow per share, while investing in the long-term opportunities of our business. We have high expectations for ourselves overtime, and we constantly drive for excellence on behalf of our customers and our shareholders.

I will now turn the presentation over to Diane to review our fourth-quarter results in more detail.

Diane Irvine, Chief Financial Officer

Thank you, Mark, and good afternoon everyone. For the fourth quarter, net sales were $73.2 million, a 13.5% increase over last year and a record fourth-quarter net sales level for Blue Nile. Gross profit for the quarter was $16.2 million, compared to $14.1 million in the fourth quarter of 2004. This represents a 14.7% increase in gross profit year over year. Our gross margin for the quarter was 22.2% as compared to last year's fourth quarter gross margin of 21.9%.

This year-on-year expansion in gross margin of 30 basis points is primarily due to product mix, with non-engagement items consisting of a higher percentage of our overall Q4 product mix compared to a year ago. These products carry a higher overall gross margin, as compared to engagement products. A key metric for our business is average order size, which was $1284 in the fourth quarter and essentially constant with the fourth quarter of 2004. Historically, our average order size is generally lowest in the fourth quarter of the year, as non-engagement jewelry, which carries a lower average unit price compared to engagement items is expected to be a higher percentage of the sales mix during Q4, based on seasonality.

Income before income taxes for the fourth quarter was $8.3 million compared to $7.1 million in the fourth quarter of 2004, an increase of 15.7%. Our net income in the fourth quarter was $5.3 million, compared to $4.6 million in Q4 a year ago. Net income per diluted share grew 20.8% for the fourth quarter to $0.29 from $0.24 a year ago. For the full year ended January 1, 2006, net sales were $203.2 million, an increase of 20% from net sales of $169.2 million in the prior year. For the full year, the engagement category represented approximately 72% of our total net sales, compared to 74% in the prior year.

Operating income for the full year 2005 was $18 million or 8.9% of net sales. This compares to operating income of $14.9 million or 8.8% of net sales for the prior year. Operating income for 2005 includes approximately $2.6 million in costs associated with being a public company, compared to approximately $1.2 million for 2004. The year-on-year increase in these costs relates primarily to Sarbanes-Oxley compliance work, which was required for Blue Nile for the first time in 2005. Net income and net income per diluted share for the full year 2005 were $13.2 million and $0.71, respectively, compared to $10 million and $0.56 per diluted share in the prior year.

I would like to review our fourth-quarter costs in more detail. We're focused on earning a compelling profit for our investors. In order to do that, we need a high-quality, low-cost business model and great discipline in our business execution. We have both, and we are focused on maintaining an SG&A expense that is today one of the lowest in all of retail as a percentage of net sales.

For the fourth quarter, SG&A expenses as a percentage of net sales increased to 11.9% from 11.4% a year ago. SG&A expenses totaled $8.7 million in Q4, compared to $7.3 million in the prior-year quarter. Increases in SG&A expenses year-over-year include increases in variable costs that move with sales volumes, such as credit card processing fees. Included in these types of costs are our marketing expenses, which increased approximately $515,000 in Q4 compared to a year ago, as a result of higher sales volumes as well as significant increases in online marketing costs.

Costs associated with being a public company also increased during the quarter, primarily related to the implementation of Sarbanes-Oxley Section 404. In the fourth quarter, the most intensive period of the year for our Sarbanes-Oxley compliance work, costs associated with being a public company increased to approximately $700,000 as compared to approximately $380,000 for the prior-year quarter. Without the incremental public company costs, our operating margin would have shown year-on-year improvement in the fourth quarter.

As we look ahead to 2006, we anticipate that our public company costs for the full year, including the costs of Sarbanes-Oxley compliance will not exceed the level of costs we incurred in 2005. As we have indicated in the past, with the absorption of public company costs in 2005, we expect our business to reflect continued leverage in SG&A expenses as we go forward. Interest income was $776,000 for the quarter, compared to $329,000 in last year's fourth quarter. The increase was due to our higher cash balance and higher interest rates compared to a year ago.

We believe one of the most informative measures of our financial performance is non-GAAP free cash flow. For the quarter, non-GAAP free cash flow of $36.8 million grew 24.1% from $29.6 million in the prior year. The ability to generate strong cash flow is fundamental to driving shareholder value, and we therefore focus on free cash flow generation as a key financial goal throughout our business.

Turning to the balance sheet, inventory at the end of the year totaled $11.8 million. Inventory consists of settings for our customized diamond products, customized jewelry that is in the process of being assembled for specific customer orders and finished jewelry such as pearls and sterling silver products. Our average inventory turnover for the trailing 12 months at the end of the fourth quarter decreased slightly to 15.6 times, compared to 16 times for the trailing 12-month period at the end of the fourth quarter a year ago.

Our financial position remained strong at January 1, 2006. We ended the year with $114.8 million in cash and marketable securities, and we have no long-term debt. Looking ahead, I would like to review our earnings guidance for the first quarter and for the full year 2006. In accordance with our policies on guidance, I would like to emphasize that this is the first time we are providing guidance for 2006. For the first quarter, we expect net sales to be between 47 and $49 million. Net income for the first quarter is expected to be between $0.11 and $0.12 per diluted share. These estimated net income per diluted share amounts include the estimated impact of expensing stock options under FAS 123R of approximately $0.03 to $0.04. Blue Nile will begin expensing stock options under these rules in the current quarter.

For the full year 2006, we expect net sales to be between 220 million and $245 million. Net income for the full year 2006 is expected to be between $0.62 and $0.72 per diluted share. These estimated net income per diluted share amounts include the estimated impact of expensing stock options under FAS 123R of approximately $0.14 to $0.16. To reiterate, this would equate to net income per diluted share of approximately $0.76 to $0.88 without stock option expensing under FAS 123R.

Actual stock compensation expense for the first quarter and for the year may differ from these estimates based on the timing and the amount of options granted, the assumptions used in valuing these options and other factors. Capital expenditures for the year are expected to total between 2.4 million and $3 million. The effective tax rate for financial statement purposes for the full year 2006 is expected to be approximately 35.8%. Blue Nile expects to begin paying cash taxes for federal income tax purposes in the second quarter 2006, as we expect to fully utilize our net operating loss carryforwards. The estimated effective tax rate does not include any potential impacts from the exercise of stock options.

I will now turn the call back to Mark for a brief closing comment.

Mark Vadon, Chief Executive Officer

Thank you, Diane. In closing, I want to thank our investors and analysts for participating on today's call. We are excited about the prospects for 2006, as we look forward to enhancing our position as the leader in online diamond and jewelry retailing and demonstrating how the unique attributes of our business can grow value for our shareholders over the long-term. 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?

Questions-and-Answer Session

Operator

At this time, I'd like to remind everyone, if you would like to ask a question, simply press '*' then '1' on your telephone keypad. We will pause for just a moment to compile the Q&A roster. Your first question is from Mark Friedman with Merrill Lynch.

Q - Mark Friedman

Thank you. Good afternoon everybody. I was wondering, Mark, if you could talk about, you talked about the three weeks in which business softened. I was wondering if you could talk about the environment as 2006 has started, to give us a better sense if this is a continuing trend, both as it relates to the competitive jewelry nature as you see it and then also on the advertising side?

A - Mark Vadon

Thanks Mark. Well, starting with the jewelry industry at large, you know, I don't think we have a tremendous amount of insight into what is going on across the industry. What we have heard from the supply base in general is that at the higher end of diamonds, that's very large sizes of diamonds, the market is pretty soft out there. We've just seen tremendous increases in pricing for large stones over the last couple of years. For perspective, if two years ago, you were shopping for a two-karat ring, so if you were going out to upgrade your wife's engagement ring and you were looking at a two-karat or three-karat stone, you might see it in the store for $40,000. That same ring in the store today, if you came in, would be 65,000 or $70,000. And the feeling on 47th Street is that the prices have gotten to the point where a lot of consumers are simply priced out of the market. So I think there is some nervousness in the diamond market about larger stones. And beyond that, I think we haven't seen a tremendous amount of data about what's going on in the market.

As far as the advertising market in general, we continue to see search just priced very high. We were frankly pretty surprised by how aggressive pricing within search got during Q4. I think over the last few years, we had focused more and more of our budget into paid search, and in Q4, the prices really started to go up. In order to give you perspective, in our top five keywords, our cost per click was up over 80% compared to a year ago. To us, it looks like, frankly, some irrational behavior in the marketplace. I think, if you follow our business, you know that we monetize Internet traffic for jewelry better than anybody in the world, and if we are getting nervous about the pricing in search, it means there's some people out there who are deficit spending and perhaps are back to the mentality of 1999.

But I think our reaction to that is to continue to play in search, but to be more conservative in what we are bidding, and then to take our money and look for other avenues to acquire customers. And we're doing that right now. So the guidance you see for the beginning of 2006 is really we're trying to be conservative as we go out and redeploy our capital into other avenues of acquiring customers. And if search becomes rational, we monitor that on a daily basis and where we see opportunities to increase our bids and it's profitable for customer acquisition, we'll do that. But I think, in general, the online market for advertising, at least in our space has gotten a little bit flossy out there.

Operator

Your next question is from Pauline Reader with Thomas Weisel Partners.

Q - Pauline Reader

Hi, just more questions on the marketing. Do you do it yourself, or do you use someone like aQuantive or someone like that to help you? And if so, is that going to change going forward? And I guess the other question is, how efficient are you? My sense is that you have always been very efficient, and I'm just wondering what you can do to be more efficient on search, or if you're just going to have to find other mediums. And on the other mediums you know, does this accelerate your plans to start marketing offline?

A - Mark Vadon

As far as the first part of the question, we don't use an agency; we do all of our own work on search. We've used agencies in the past, and overtime we've just built that capability up in-house. We feel it's strategically an important thing to have in-house. So we have, both on the marketing side and the technology side, resources dedicated to analyzing and bidding for online keywords. And we will continue to play in that market. If you look at the sources of new customers for us, our number one source of new customers continues to this day to be referral. It's all just driven off of delivering a tremendous experience. And we saw in Q4, the core of the business, repeat purchasing referral purchasing, did extremely well, as it always has. And beyond that, though, the number one source of customers for us is search, is paid search. And I suspect it will continue to be, but I think we can't, in Q4, we relied a little too heavily on search to continue to show the type of growth it had been, and where the pricing got to, we just going to do that.

So I think we do measure efficiency continuously in that market and where it's efficient, when it's efficient to bid, we will. And if you go out there and check all the keywords, you'll see us up there. It's just at certain levels, we might choose to fall down to a lower position of the bidding, rather than slugging it out for the first position. And I think to some degree, people follow our bidding in the marketplace, people who are not analyzing things as robustly as we are. And so right now, we are backing off a little bit on search. What it means for us is we're going to need to go out, and I think this is an ongoing story with this business. For those of you who have followed this business overtime, if you go back to the original business, we went from zero revenue to $44 million of revenue in a year. And at the time, people who were following us put a straight line through those two data points and had us getting to a couple billion dollars within a few years. And obviously, that didn't happen. And as we went from 44 million, and last year we went from 44 million to 48 million, and plateaued. And people again put a straight line between 44 and 48, and we couldn't secure funding at the time, even though we were a profitable business in the private market, because people basically said, you are going to cap out at 60 million of revenue.

That didn't happen. And what was going on at that period in time was portal pricing had gotten ridiculous. And we said, hey, this doesn't make sense. We backed out of it. We found a different way to redeploy the money. And from there, we grew from 48 to 72 to 129. And honestly, at that point, while we were on our roadshow with 129 million in trailing revenue, people were looking at 60, 70% growth. And we were telling people, don't expect 60 or 70% growth on this business. But again, I think people are quick to extrapolate trends very far into the future.

Today, if you look at Q4 or our guidance for Q1, it's a little bit soft. But we believe it's just a matter of when we bring in a customer, we can monetize them quite well. And we're going to need to look at other avenues, and we are already doing that. Will we go offline? If the prices of online customer acquisition get high enough, offline at some point makes sense. And we're out there costing out some different avenues offline as well. And we may play with those in the coming quarters. So I think the overall story, though, for us is we feel we are still right on track to build $1 billion business. There maybe quarters where that growth is very rapid, as it were a couple of years ago, and there maybe quarters where the growth is rather soft, as it was in the year 2000. But overall, if you look at this, as we are trying to do, with a five or ten-year time horizon, we think there's tremendous growth.

And just the online market continues, sorry for the long-winded answer, but the online market continues to evolve very, very rapidly. And so I think it means we just have to be willing, especially for a business like ourselves, where a lot of the business is still acquiring new customers as opposed to mining an existing customer base, we have to just be very ready to go out and try new things and constantly tactically change how we are acquiring new customers. So that's what we're doing right now in Q1, and that's the challenge as we go through 2006 is to find profitable, efficient ways to bring new customers in the door.

Q - Pauline Reader

And how much, if you can give us any kind of color on how much of your marketing budget goes to search, what you would like that to be? I realize it depends on what happens with prices. And then, kind of how long it takes to find more efficient ways of acquiring consumers?

A - Mark Vadon

Search is, I'll just say it is larger than any other channel of marketing for us. It is much larger today than portals would be or affiliate networks or like that. And I'm not saying we are by any means going to stop spending in search. It will continue, I would think, for many years to be our largest channel of spending. But what I'm trying to say is we can't rely on that to be the only growth channel for the business. As far as cultivating new channels, it's something we do on an ongoing basis. Every quarter we are trying new things. It's just at this point, we're willing to go and invest more aggressively in some of those other things, rather than simply put the money into search. So we'll be working on that and we'll give you sort of progress as we go through the year.

Q - Pauline Reader

Okay, thanks.

A - Mark Vadon

Thanks, Pauline.

Operator

Your next question is from Dan Geiman with McAdams Wright Ragen.

Q - Dan Geiman

Hey, good afternoon. Any fallout during the quarter from the GIA scandal that you saw, in terms of deteriorating customer trust and confidence, particularly with the online buying process? Also, were there any added costs as a result to your own review and certification process? I'm also wondering if you can talk a little bit about the pricing dynamics in the industry and the impact on sales, given that I know you mentioned the large increase in prices over the last couple of years. But over the last year, really, my understanding is that prices increased a little bit more modestly.

A - Mark Vadon

Sure. First, to the GIA scandal, just for people listening who haven't followed this, there was an issue with some GIA diamonds in our New York laboratory which, allegedly, the grades on those diamonds were inflated due to payoffs that happened to individuals who worked within the lab. From everything we understand, it was a very confined incident. And it dealt with a small handful of stones, all of them worth many millions of dollars each. As far as consumer reaction, there have been a few media reports on it. We've been monitoring our inbound calls to measure the reaction, and we've had a grand total of eight phone calls from it. So for consumers, I don't think there has been much reaction. I don't think many people are aware of it, and the people who are aware of it, I think, are pretty comfortable that this has to do with multi-million-dollar diamonds, and people are not paying off an inspector to change the grade on their $1500 diamonds.

So we monitor that, and are out there actually talking to the press whenever someone is writing about it. But as far as consumers, I don't think it's been an issue at all. Pricing dynamics, I think there's different parts of the market. I think, overall, pricing has tended to stabilize. What we're seeing is for smaller stones, there's actually some downward pressure on pricing as we enter 2006. There seems to be a lot of those goods in the marketplace, and we're seeing backlogs. For larger stones, pricing continues to be very, very aggressive, continues to go up very, very aggressively. So it depends on which part of the market. It's not something that we think, over the last couple of quarters has had a material impact on our business, which is why we didn't call it out in today's phone call.

Q - Dan Geiman

Thanks.

A - Mark Vadon

Thanks, Dan.

Operator

Your next question is from Scott Devitt with Stifel Nicolaus.

Q - Scott Devitt

Thanks. I had a question Mark for you, and then if I could follow up with Diane, as well. On the marketing spending, again, a couple of questions there. Is it mostly related to online larger competitors, or in terms of the excessive spending that you are referring to? When I do keyword searches under some of the more significant keywords that you do, it seems like the industry itself is competing with you. The Diamond Trading Company seems to be a pretty significant bidder these days. I'm wondering where the breakdown is in terms of, say, an Amazon versus industry versus some of these smaller merchants that are trying to drive traffic directly to their own sites, whether they be wholesalers or whatnot? And just to follow onto that as well, so you can answer all in one, as you drive traffic to your onsite, are you noticing any changes in the conversion rate?

A - Mark Vadon

Sure. As far as who is out there bidding, it's slightly different in Q4 as opposed to Q1. I think in Q4, you asked about Amazon. We haven't seen them at all in the online search market. We saw a couple larger players; I think Zales was pretty aggressive, Macy's was pretty aggressive. And then we see just a tremendous number of small players, and these are very small companies. And they don't play for very long. They will come into search for a week or a couple of weeks. And I think there's just a lot of, and then I think they burn through their budget fairly quickly and fall off the screen. But we just saw a lot of those types of players coming out. And then, just in Q1, we're seeing some odd search behavior. A couple weeks back, you know I think, if anything, this is the time that there's a little bit too much aggressiveness in search. A couple of weeks back, we saw MSN Shopping appear on Google. And that's in our category; it's also in a number of other categories. MSN Shopping began bidding to take customers from Google over to MSN Shopping. And for those of you who understand the cost per click on a Google, which is very targeted, versus a shopping channel, those economics are not going to make sense. So we see things like that, and we just feel like there's something going on here; it's a little too frothy.

As far as conversion rates, we continue to be able to convert quite well when we bring people in. I think, to some extent, there may be some downward pressure, and the conversion from every single channel is different. If you look at our overall conversion rate in Q4 versus last year, the conversion was quite good. But within channels it will differ. Within search, what we're seeing, a slight downward pressure on the value of any customer coming out of search, if that makes sense. If you look at, the measures we're looking at is revenue per visitor or gross margin per visitor over time, and then isolating that down to a single channel. So, for those of you don't follow the search market, as well, the way as a merchant you really try to understand your numbers is look at the gross margin or contribution margin per customer coming off the flow of traffic, and you simply weigh that against the price to acquire those customers. And as you go up higher in search, you're trading off perhaps more volume from higher placement with lower profitability from the stream of traffic.

So an important matter is how well you can convert. Over time from search, we see slight declines, and it's not tremendous but slight declines in the conversion rate. I think, to some extent, that has to do with the search engines placing more ads. So, when you went to a search term a year ago versus going to it today, you are going to see more paid search placements today than you did a year ago. And as there's more people there competing for the same traffic, if one consumer is shopping, so if you're shopping for a plasma TV, you are probably going to go to many merchants, or at least a handful of merchants, before you make your purchase. And so you will be clicking on multiple ones of those, but only buying one plasma screen. And the more paid placements there are, probably the more click-throughs you're going to have.

So what that results in for merchants is downward pressure on the value of those customers. So just as bidding is going up, you're seeing downward pressure in conversion. Again, this points to our desire in the channel to be less aggressive with our bidding. And if that means giving up some volume to other people who perhaps are not measuring that and doing that ROI calculation, as well, we will do that until it rationalizes somewhat. I think that answered, if you had other questions, I think I'd answered those, though.

Q - Scott Devitt

Yes, it did, thanks. Diane, if you could just update me on the remaining buyback? I may have missed that, in terms of what is remaining still from this existing buyback. And then also, if you're willing to throw a guess out there, in terms of free cash flow at the midpoint of your cash EPS range, just with the remainder of the NOL and the working capital. I'm struggling to get to a number.

A - Diane Irvine

Sure. On the buyback, that program was a 12-month program that we entered into a year ago. So that program will end shortly. We have spent a little over $17 million; that was a $30 million program, as you recall. So there was a little under $13 million that was not spent. And then the new $100 million program over 24 months will begin shortly, so the old program will be replaced by the new program. On free cash flow, are you looking at this year?

Q - Scott Devitt

2006.

A - Diane Irvine

Yes. We, I guess, haven't given free cash flow guidance. But certainly, if you look at what we have always targeted, generally in terms of our topline growth, we have felt like 20 to 30% growth would equate to 25% growth on the bottom line. And certainly that will remain our goal in free cash flow. Now, as you see our guidance for the year, we are a bit more conservative coming into the year. Potentially, there's an impact, but we are all about driving profitability, driving our free cash flow. So, as Mark said, we have high expectations for ourselves, so we will be looking to drive every dollar of free cash flow. And we want to achieve those longer-term targets there.

Q - Scott Devitt

Thank you.

Operator

Your next question is from Imran Khan with JP Morgan.

Q - Imran Khan

Yes, thank you. I have couple of questions. One, in terms of your organic traffic, can you give us a sense what percentage of your traffic is not coming through some sort of advertisement, but directly going to you through organic search or just as a brand reference, and how it has been trending over the last couple of years? And secondly, Mark, you talked about in terms of looking for different avenues of advertising. I was wondering if you have tested other side of advertisement. It seems like you are trying to delimit yourself to the online advertisement. And I think I talked to you a couple of months ago where it seems like marketing is not something you are a great fan of, so I was wondering what other areas you might look into, in the online advertisement side. And if you have tested them, and if you have tested, what kind of conversion you're seeing from those?

A - Mark Vadon

On the organic traffic, I'll just say we haven't broken out the traffic before. I would just say, though, the way we think about the organic part of the business is the repeat buying and the referral buying that's out there. To some degree, that's hard to measure, because even referral customers use other ways in the front door. Not all of them type it in directly; they might use a search engine or such. When they use a search engine, it tends to be very cost-efficient, anyway, because your trademark is probably the cheapest term you can buy. But those two things together, repeat and referral, are just very ballpark, roughly half of the business. And they has shown just great growth over time. The repeat part has been phenomenal, and referral just keeps chugging along. So in quarters like Q4, they have increased as a percentage of the business. On what we are testing, we are running quite a few tests right now and have been. We are really reluctant to go into detail about what we are testing, partly because what we have seen in the past is a lot of our smaller competitors using this phone call and our 10-K as kind of their playbook for what they do. So we are doing things in the background. Ones that have worked historically we've scaled up; I think we've got some interesting things coming up in Q1. But we are really reluctant to articulate exactly what those are.

Q - Imran Khan

Okay, thank you.

Operator

Your next question is from Steven Jue with RBC.

Q - Jordan Rohan

It's Jordan Rohan here. I'm trying to interpret the topline growth guidance for the year, which, according to the numbers that I see before me, calculates at the high end to 20.5% revenue growth for '06 versus '05. And the specific question that I have for you is, does this topline growth guidance, this revenue growth guidance, tie to a situation where people continue, or small online commerce players continue to bid aggressively in search, and therefore you have to shy away from some of the keywords that you traditionally had prominent placement on? Or is this assuming some reversion to mean or historical performance, where people are acting rationally in search?

A - Mark Vadon

I think what we are trying to do with the guidance we put out there for the year is put a relatively wide range of guidance around it, which you guys can see in the numbers we've given. Because I think it is relatively uncertain what's going to happen in the market. We are not making any assumptions behind the scenes about exactly what different people in the competitive set are going to do. We just feel the guidance we've given encompasses the range of outcomes that could potentially occur. And so we haven't made, in order to get to that top number, there's not necessarily any set of assumptions we've made about competitive behavior. I don't know, Diane, if you have other things?

A - Diane Irvine

Yes. And Jordan, I would also say we haven't changed our long-term goals, in terms of our topline growth, which I was just mentioning in the prior question. So we are still very much about growth, and we will hope to come back to you this year and talk about greater growth. That's what we're all about here. So there was nothing in those numbers other than, I think, appropriate conservatism after Q4 results.

Q - Jordan Rohan

When it comes to the results for your search engine marketing outside the US, particularly in the UK, can you speak to the competitiveness of those search bidding auctions for the keywords that you are interested in? Is your return on investment there any better than it is in the US?

A - Mark Vadon

We do very, very little today in search internationally. Our website in the UK, we are quite happy with our website in the UK, by the way. It has got just a trickle of traffic coming into it, but it's converting very, very well and it has been scaling. Again, it's a relatively small base, and you can put out very large growth numbers when you've got a small base of sales. But we are very happy with how that has been happening. As far as competition, I think, as you get into some of the markets outside of the US, there's almost no competition. And that's one of the reasons we are in the UK trying to build that business. And I look back at 2005, and potentially in 2005, it was even early for us to go international.

There was still so much left to be done in the United States. And, you know with limited resources as a company, it was a hard decision for us whether or not to go internationally. But a big push was there are not, there is no one who is doing what we're doing overseas. So when we go into a market like the UK and bid on search, there's not a lot of competition there today. So I think that is still a, that market is still relatively undeveloped, and so we have got a smaller product line in the UK. We've got much less brand awareness than we have in the US, but we are seeing good conversion, and I just think if we are in the early stages of the business in the US and the UK, we fairly have got started.

Q - Jordan Rohan

Thank you very much.

Operator

Your last question comes from Mark Friedman with Merrill Lynch.

Q - Mark Friedman

Hi, guys. I have a followup question, Mark. I was just wondering, as you were talking about the higher-end part of the market being softer, if that meant that going forward, you might look in the near term to potentially rechannel some of your focus on the product and go after the lower part of the market. I don't mean lower meaning, I mean relative to where you have been in recent quarters?

A - Mark Vadon

We have no desire to downgrade sort of the quality of the product or downgrade the brand. I think that would be very shortsighted, and we don't want to react to strength in one part of the market or strength in another part of the market to reposition the brand. We think, strategically, the brand is exactly where it should be for the long term. So, as far as what we're doing with the product line in general, over time we keep, within diamonds, we want to have that same focus, which is we won't let the quality slip. If you are buying a diamond from us, you can be assured that it's going to be an absolutely incredible diamond. And we do the work on the back end to make sure that anything offered on our site is exceptional. What we're doing with the product line beyond diamonds over time is continuing to develop and build that business. We still want to have a very edited selection. We don't want to have everything for everybody. But over time, as we have more and more repeat buying, we want to make sure that we have the right products there for our customers.

Over time, as there's a lot of brides out there now walking around with Blue Nile rings who have a tremendous passion for the brand, because they associate the brand with their entire engagement experience, they are coming to the website and buying. They tend to buying lower price point items more as accessories, but we want to make sure we've got the right products for them, as well. So you'll see us doing slightly more fashion things. We've done a lot more in gemstones this year than we ever have before, and so we will continue to expand the assortment and add a little bit more flavor, a little bit more fashion. But certainly, we won't change the quality of the product or, strategically, where the brand is positioned.

Q - Mark Friedman

I'm sorry if I wasn't clear. I didn't mean to imply that you would take it downscale. I was just…..

A - Mark Vadon

You almost insulted me there, Mark.

Q - Mark Friedman

No, no, no. Far from it. What I really meant was to differentiate the 20,000 and up type of purchase versus where your average purchase is, in the kind of 6,000, $7,000 range. I was just curious if it seems like at times you have made some slight adjustments to the way you targeted your website and other things, because that business was so healthy in the past year at times, if, because there was more weakness in the fourth quarter, that you would make the slight adjustment to let's call it the upper-income market versus the super-wealthy.

A - Mark Vadon

Oh, I got you. We are constantly sort of adjusting and tweaking the website to maximize the value of traffic coming in the door. And so we do that based on everything from seasonality; you know, there's times of the year where we are stronger. Both in the website presentation and in outbound marketing, there's times of the year where we will emphasize engagements. There's times of the year where we will deemphasize that and try to put sort of entry product lines on the website. So we'll move that around, but I think, really, our goal going forward is to make the entire website and the outbound marketing more personalized to the individual. That's something we have been playing with on the outbound e-mail front, is looking at your purchasing behavior.

So if we have data in our database that's telling us that you are making purchases at the high end of the market, when we send you e-mails, the e-mails will feature, so we just sent out an e-mail. I know I've spent too much money with Blue Nile personally when I got the e-mail that's geared toward the highest-end customers. But I got an e-mail which was all products that were above $5,000 in ticket. There's e-mails like that going out. Simultaneously, there's e-mails to other customers if we've seen them buying at lower price points or we've seen them, you know, I think there's more we can do to target that. But if we've seen them not shopping for those high-end items, we will personalize that.

I think, over time, we want to do that same thing with our website, is to try to understand, based on your behavior on the site, what you're looking for and then tune the site to you. Because I think the ideal, the greatest thing about the Internet over time is I think you can personalize it to the individual, rather then, we don't need one storefront for everybody. Hopefully, over time, we will have a storefront that's specifically geared towards Mark Friedman, and will show you what we believe you want to see, based on your behavior.

Q - Mark Friedman

Okay, thank you.

A - Mark Vadon

Thanks, Mark.

Operator

At this time, there are no further questions. Are there any closing remarks?

Mark Vadon, Chief Executive Officer

Sure. I just want to thank everybody for joining us today, and we look forward to talking to all of you next quarter. Thanks.

Operator

This concludes today's conference call. You may now disconnect.

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Source: Blue Nile Inc. Q4 2005 Earnings Conference Call Transcript (NILE)
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