The following discussion should be read in conjunction with our consolidated financial statements and the related notes contained elsewhere in this Quarterly Report on Form 10-Q and the Annual Report on Form 10-K filed for our fiscal year ended January 1, 2012. The following discussion contains forward-looking statements that reflect our plans, estimates and beliefs. Our actual results could differ materially from those discussed in the forward-looking statements. Factors that could cause or contribute to these differences include those discussed below and elsewhere in this Quarterly Report on Form 10-Q, particularly in "Risk Factors."
Management Overview
We are the leading online retailer of high-quality diamonds and fine jewelry. We offer our products for sale through the www.bluenile.com website in over 40 countries and territories throughout the world. Our primary focus is on growing our business by providing unparalleled selection and value to consumers and delivering exceptional customer service.
Our online business model allows us to avoid many of the costs that are typically incurred by physical retail stores. As a result, we are able to realize lower gross profit margins while remaining profitable. Our lower gross profit margins result from lower retail prices that we offer to our customers. We believe that our unique product selection, connection with our customers through our marketing and customer service efforts, and our competitive pricing will result in increasing our sales and market share.
We are focused on accelerating the sales growth rate of our business through initiatives across three main categories: 1) the sale of engagement products in the U.S.; 2) the sale of non-engagement products in the U.S.; and 3) the sale of both engagement and non-engagement products in international markets. The engagement product category includes gold or platinum engagement rings with a diamond center stone and loose diamonds. Our non-engagement product category includes rings, earrings, necklaces, pendants, bracelets, gifts and accessories containing precious metals, diamonds, gemstones, or pearls.
We believe that value is one of the most important drivers of engagement sales, and the current costs of diamonds is a significant factor to our growth rate. Generally, we purchase our diamonds on a real time basis from our suppliers when a customer places an order for a specific diamond. When the cost of diamonds is relatively steady or declines, we believe that our business benefits because we are able to immediately pass those lower costs on to consumers. Throughout 2012, we have benefited from a year-over-year decrease in the cost of diamonds. These lower costs, along with our aggressive retail pricing, increases our value proposition compared to our bricks and mortar competitors, who are carrying diamond inventory that was purchased months earlier at higher costs. To accelerate growth in our non-engagement category, we are concentrating our marketing efforts on acquiring new customers. We are also investing to increase the number of products offered on our website to appeal to a greater number of customers. The total addressable market for the sale of non-engagement products is much greater than that for engagement, and we believe our brand is well positioned to attract new customers. Additionally, we believe that customers who purchase our non-engagement products will return to place orders in the future at a higher cumulative value than those who initially purchased an engagement product. The higher value of future purchases, coupled with relatively higher gross profit as a percentage of revenue than we earn selling our engagement products, creates a compelling opportunity for us to invest in this category for growth. During the first three quarters of 2012, these investments increased our selling, general and administrative expenses and increased the amount of inventory we carried compared to the same period last year. We believe that these investments will lead to increased growth in this category of our business and provide higher profitability over the long-term.
As part of our plan to accelerate growth in our international business, we are increasing our investment to provide a greater localized experience in key countries. This includes expanded website functionality, increased product offerings, native language websites and customer service personnel, and other strategic investments. Additionally, the pricing dynamics of diamond supply on our engagement products apply to prices offered to our international customers increasing our value proposition compared to our competitors.

Third Quarter of 2012 Summary of Results of Operations We achieved third quarter net sales of $89.8 million, a 19.8% increase from the third quarter of 2011. Through our increased marketing efforts, orders from new customers increased 22.4% in the third quarter of 2012 compared to the third quarter of 2011. Net sales in our international markets decreased 3.3% from the third quarter of 2011 and comprised approximately 15.5% of our total net sales for the quarter. Our gross profit increased $2.1 million in the third quarter of 2012, a 14.1% increase compared to the third quarter of 2011. Net income per diluted share was $0.14 in the third quarter of 2012, compared to $0.13 for the third quarter of 2011.

Results of Operations
Comparison of the Quarter Ended September 30, 2012 to the Quarter Ended
October 2, 2011
The following table presents our operating results for the quarters ended
September 30, 2012 and October 2, 2011, including a comparison of the financial
results for these periods (dollars in thousands, except per share data):

                                                       Quarter ended
                                               September 30,      October 2,
                                                   2012              2011         $ Change      % Change
Net sales                                    $        89,830     $    74,987     $  14,843         19.8  %
Cost of sales                                         72,900          60,149        12,751         21.2  %
Gross profit                                          16,930          14,838         2,092         14.1  %
Selling, general and administrative expenses          14,264          11,978         2,286         19.1  %
Operating income                                       2,666           2,860          (194 )       (6.8 )%
Other income, net:
Interest income                                           20              33           (13 )      (39.4 )%
Other income (expense), net                               16             (20 )          36        180.0  %
Total other income, net                                   36              13            23        176.9  %
Income before income taxes                             2,702           2,873          (171 )       (6.0 )%
Income tax expense                                       961           1,004           (43 )       (4.3 )%
Net income                                   $         1,741     $     1,869     $    (128 )       (6.8 )%
Basic net income per share                   $          0.14     $      0.13     $    0.01          7.7  %
Diluted net income per share                 $          0.14     $      0.13     $    0.01          7.7  %

Net Sales
Net sales increased 19.8% during the third quarter of 2012 as compared with the third quarter of 2011, due primarily to an increase in the number of orders shipped, partially offset by a decrease in the average shipment value. Net sales in the U.S. increased 25.3% to $75.9 million for the third quarter of 2012, compared with $60.6 million for the same quarter last year. U.S. engagement net sales for the third quarter of 2012 increased 31.5% to $54.1 million, compared to $41.1 million for the third quarter of 2011. U.S. non-engagement net sales for the third quarter 2012 increased 12.0% to $21.8 million, compared to $19.4 million for the third quarter 2011.
International net sales decreased 3.3% to $13.9 million from $14.4 million in the third quarter of 2011 due to a decline in high value orders. Internally, we monitor our international sales performance on a non-GAAP basis which eliminates the positive or negative effects that result from translating international sales into U.S. dollars ("constant exchange rate basis"). Changes in foreign exchange rates during the third quarter of 2012, compared to the rates in effect during the third quarter of 2011, had a negative impact of approximately 1.8% on international net sales. Excluding the impact of changes in foreign exchange rates, international net sales decreased 1.5% for the third quarter of 2012 compared to the third quarter of 2011.

Gross Profit
Gross profit in the third quarter of 2012 increased 14.1% to $16.9 million from $14.8 million in the third

quarter of 2011. The increase in gross profit resulted primarily from the growth in net sales. Gross profit as a percentage of net sales was 18.8% for the third quarter of 2012 compared to 19.8% for the third quarter of 2011. The decrease in gross profit as a percentage of net sales resulted primarily from changes in our product mix. Our engagement products provide lower gross profit as a percentage of revenue than our non-engagement products. In the third quarter of 2012, sales of our engagement products grew faster than our non-engagement products and equaled 72.8% of our total revenue versus 70.7% in the third quarter of 2011. Costs for our products are impacted by prices for diamonds and precious metals including gold, platinum and silver, which rise and fall based upon global supply and demand dynamics. In making retail pricing decisions, we take into account fluctuations in the pricing of diamonds and precious metals, which in turn, affect the gross margin that we realize from such products. We expect that gross profit will continue to fluctuate in the future based on changes in product acquisition costs, particularly diamond prices, product mix and pricing decisions.
Selling, General and Administrative Expenses Selling, general and administrative expenses increased 19.1% to $14.3 million in the third quarter of 2012 compared to $12.0 million in the third quarter of 2011. Compensation and benefits expense increased $1.3 million due to increased headcount to support key business initiatives coupled with increased variable incentive compensation accruals. Marketing and advertising costs increased $0.7 million in the third quarter of 2012, primarily due to increased spending on online marketing vehicles and other marketing efforts to acquire new customers in our domestic and international markets. Credit card interchange and payment processing fees increased approximately $0.4 million in the third quarter of 2012 due primarily to higher sales volumes. These expense increases were partially offset by a $0.4 million decrease in stock based compensation expense. This decrease is primarily due to the turnover of our chief executive officer ("CEO") position, resulting in a lower number of options outstanding at a lower option fair value. As a percentage of net sales, selling, general and administrative expenses were 15.9% in the third quarter of 2012 compared to 16.0% in the third quarter of 2011.
Operating Income
Operating income was $2.7 million in the third quarter of 2012 compared to $2.9 million in the third quarter of 2011. The $0.2 million decrease in operating income is primarily due to the $2.3 million increase in selling, general and administrative expenses partially offset by the $2.1 million increase in gross margin.
Income Taxes
Our effective tax rate increased to 35.6% in the third quarter of 2012 from 35.0% in the third quarter of 2011. The 2012 tax rate includes an increase in permanent differences related to certain international expenses that are capitalized for income tax purposes but expensed in the financial statements.

Comparison of the Year to Date Ended September 30, 2012 to the Year to Date
Ended October 2, 2011
The following table presents our operating results for the years to date ended
September 30, 2012 and October 2, 2011, including a comparison of the financial
results for these periods (dollars in thousands, except per share data):

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  Table of Contents

                                                     Year to date ended
                                               September 30,        October 2,
                                                    2012               2011         $ Change      % Change
Net sales                                    $        263,914     $    235,689     $  28,225         12.0  %
Cost of sales                                         214,515          186,758        27,757         14.9  %
Gross profit                                           49,399           48,931           468          1.0  %
Selling, general and administrative expenses           44,190           38,299         5,891         15.4  %
Operating income                                        5,209           10,632        (5,423 )      (51.0 )%
Other income, net:
Interest income                                           105              116           (11 )       (9.5 )%
Other income, net                                          96               61            35         57.4  %
Total other income, net                                   201              177            24         13.6  %
Income before income taxes                              5,410           10,809        (5,399 )      (49.9 )%
Income tax expense                                      1,937            3,680        (1,743 )      (47.4 )%
Net income                                   $          3,473     $      7,129     $  (3,656 )      (51.3 )%
Basic net income per share                   $           0.26     $       0.50     $   (0.24 )      (48.0 )%
Diluted net income per share                 $           0.25     $       0.48     $   (0.23 )      (47.9 )%

Net Sales
Net sales increased 12.0% during the year to date ended September 30, 2012, compared with the year to date ended October 2, 2011, due primarily to an increase in the number of orders shipped, partially offset by a decrease in the average shipment value. Net sales in the U.S. increased 13.3% to $221.5 million during the year to date ended September 30, 2012, compared with $195.6 million during the year to date ended October 2, 2011. U.S. engagement net sales for the year to date ended September 30, 2012 increased to $152.9 million from $130.0 million for the year to date ended October 2, 2011. U.S. non-engagement net sales for the year to date ended September 30, 2012 were $68.6 million, compared to $65.5 million for the year to date ended October 2, 2011.
International net sales increased 5.7% in the year to date ended September 30, 2012 to $42.4 million, from $40.1 million in the year to date ended October 2, 2011. Foreign exchange rates during the year to date ended September 30, 2012, compared to the rates in effect during the year to date ended October 2, 2011, had a negative impact of approximately 1.8% on international net sales. Excluding the impact of changes in foreign exchange rates, international net sales increased 7.5% in the year to date ended September 30, 2012 over the year to date ended October 2, 2011.
Gross Profit
Gross profit increased $0.5 million to $49.4 million in the year to date ended September 30, 2012 compared to $48.9 million in the year to date ended October 2, 2011. The increase in gross margin dollars resulted primarily from an increase in net sales. Gross profit as a percentage of net sales was 18.7% in the year to date ended September 30, 2012 as compared to 20.8% in the year to date ended October 2, 2011. This percentage decrease was primarily due to product mix. Engagement net sales was 70.9% of our total year to date revenue versus 68.9% in the prior year.
Selling, General and Administrative Expenses Selling, general and administrative expenses increased 15.4% to $44.2 million in the year to date ended September 30, 2012 compared to $38.3 million in the year to date ended October 2, 2011. Marketing and advertising costs increased $3.4 million, primarily due to increases in online marketing vehicles and other marketing strategy efforts to acquire new customers in our domestic and international markets. Compensation and benefits expense increased $1.8 million due to increased headcount to support key business initiatives and higher incentive compensation accruals. Credit card interchange and payment processing fees increased approximately $0.6 million due to higher sales volumes. Accounting and legal fees increased $0.3 million due to international expansion and strategic initiatives. Recruiting fees of $0.3 million primarily related to our CEO search also contributed to the

increase in selling, general and administrative expenses. Credit card fraud reserve increased $0.2 million primarily due to higher fraud write-offs during the quarter. These increases were partially offset by a decrease in stock-based compensation expense of $1.4 million primarily due to turnover in our CEO position as our former CEO had more options outstanding at higher option fair values than those held by our current CEO. As a percentage of net sales, selling, general and administrative expenses were 16.7% in the year to date ended September 30, 2012, as compared to 16.2% in the year to date ended October 2, 2011.
Operating Income
Operating income decreased 51.0% to $5.2 million in the year to date ended September 30, 2012 compared to $10.6 million in the year to date ended October 2, 2011. The decrease in operating income for the year to date ended September 30, 2012 was due to an increase in selling, general and administrative expenses.
Income Taxes
Our effective tax rate increased to 35.8% in the year to date ended September 30, 2012 from 34.0% in the year to date ended October 2, 2011. The 2012 tax rate includes an increase in permanent differences related to international expenses that are capitalized for income tax purposes but expensed in the financial statements.
Liquidity and Capital Resources
We have been primarily funded by our cash flows from operations. The significant components of our working capital are inventory and liquid assets such as cash and trade accounts receivable, reduced by accounts payable and accrued expenses. Our business model typically provides certain beneficial working capital characteristics. While we collect cash from sales to customers within several business days of the related sale, we typically have extended payment terms with our suppliers.

Our liquidity is primarily dependent upon our net cash from operating activities. Our net cash from operating activities is sensitive to many factors, including changes in working capital and the timing and magnitude of expenditures. Working capital at any specific point in time is dependent upon many variables, including our operating results, seasonality, inventory management and assortment expansion, the timing of cash receipts and payments, and vendor payment terms.
As of September 30, 2012, we had a working capital deficiency of $9.2 million, including cash and cash equivalents of $30.2 million and inventory of $28.9 million, offset by accounts payable of $66.9 million. Current levels of cash and cash equivalents reflect the strategic decision to repurchase $38.9 million of our common stock shares in the year to date, resulting in the negative working capital. We believe that our current cash and cash equivalents as well as cash flows from operations will be sufficient to continue our operations and meet our capital needs for the foreseeable future.
Net cash of $21.0 million was used in operating activities for the year to date ended September 30, 2012, compared to net cash used in operating activities of $31.2 million for the year to date ended October 2, 2011. The decrease in cash used for operating activities was attributable to a lower net payment of accounts payable and accrued liabilities in the current year. Net payment of accounts payable totaled $28.9 million for the year to date ended September 30, 2012 compared to $37.1 million for the year to date ended October 2, 2011. The net payment of accrued liabilities totaled $3.5 million for the year to date ended September 30, 2012 compared to $7.1 million for the year to date ended October 2, 2011. In the first quarter of each year, we generally have a significant pay down of our accounts payable balance built up during the previous year's fourth quarter holiday season. Net sales in the fourth quarter of 2011 were lower than net sales in the fourth quarter of 2010, resulting in lower net payment of payables in the year to date ended September 30, 2012 compared to the year to date ended October 2, 2011. Further, inventories decreased $0.4 million from January 1, 2012 compared to a $2.9 million increase from January 2, 2011, resulting in a net $2.5 million decrease in cash used for the current year.
Net cash of $6.1 million was used in investing activities for the year to date ended September 30, 2012. Net cash of $2.1 million was used for the purchases of property and equipment to support our operations. Net cash of $4.0 million was used to purchase preferred shares in a privately-held company and a loan to the same privately-held company in exchange for a note receivable. Net cash of $4.7 million was used in investing activities for the

year to date ended October 2, 2011 for purchases of property and equipment primarily related to the move of our corporate offices. Our capital needs are generally relatively low and include, without limitation, investments in technology and website enhancements, capital improvements to our leased warehouse and office facilities, and furniture and equipment.
Net cash used in financing activities for the year to date ended September 30, 2012 was $32.1 million, primarily related to the repurchase of common stock of $38.9 million, partially offset by $6.8 million of proceeds from stock option exercises. Net cash used in financing activities for the year to date ended October 2, 2011 was $37.3 million, primarily related to the repurchase of common stock, partially offset by proceeds from stock option exercises.
On February 7, 2012, our board of directors authorized the repurchase of up to $100.0 million of our common stock during the 24-month period following such approval date. During the year to date ended September 30, 2012, we repurchased an aggregate of 1,491,986 shares of our common stock for $38.9 million. Since the reauthorization on February 7, 2012, we have repurchased an aggregate of 1,491,986 shares for a total of $38.9 million. As of September 30, 2012, approximately $61.2 million remains under this repurchase authorization, subject to limitations under Delaware law.
Since the inception of the buyback program in the first quarter of 2005, we have repurchased an aggregate of approximately 7.5 million shares for a total of $265.3 million. Our shares may be repurchased from time to time in open market transactions or in negotiated transactions off the market. The timing and amount of any shares repurchased is determined by our management based on their evaluation of market conditions and other factors, including our cash needs. Repurchases may also be made under a Rule 10b5-1 plan. We continually assess market conditions, our cash position, operating results, current forecasts and other factors when making decisions about stock repurchases.
We do not carry any long or short-term debt other than trade payables, deferred rent and other short-term liabilities incurred in the ordinary course of business. However, projections of future cash needs and cash flows are subject to many factors and to uncertainty. We continually assess our capital structure and opportunities to obtain credit facilities, sell equity or debt securities, or undertake other transactions for strategic reasons or to further strengthen our financial position.
Contractual Obligations
There have been no material changes to our contractual obligations during the period covered by this report from those disclosed in our Annual Report. Off-Balance Sheet Arrangements
As of September 30, 2012, we did not have any off-balance sheet arrangements that have or are reasonably likely to have a current or future material effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources.
Non-GAAP Financial Measures
To supplement our consolidated financial statements presented in accordance with GAAP, our management internally monitors our sales performance on a non-GAAP constant exchange rate basis that eliminates the positive or negative effects that result from translating international sales into U.S. dollars. Our management does not itself, nor does it suggest that investors should, consider such non-GAAP financial measures in isolation from, or as a substitute for, financial information prepared in accordance with GAAP. Investors should also note that the non-GAAP financial measures we used may not be the same non-GAAP financial measures, and may not be calculated in the same manner, as that of other companies. Whenever we use such non-GAAP financial measures, we provide a reconciliation of non-GAAP financial measures to the most closely applicable GAAP financial measures. Investors are encouraged to review the related GAAP financial measures and the reconciliation of these non-GAAP financial measures to their most directly comparable GAAP financial measures.
The following table reconciles year-over-year international net sales percentage increases (decreases) from the

GAAP sales measures to the non-GAAP constant exchange rate basis:

Quarter ended                                Effect of foreign    Year over year growth on
September 30, 2012     Year over year growth exchange movements constant exchange rate basis
International net
sales                         (3.3)%               (1.8)%                  (1.5)%
Quarter ended October                        Effect of foreign    Year over year growth on
2, 2011                Year over year growth exchange movements constant exchange rate basis
International net
sales                          54.8%                8.6%                   46.2%




Year to date ended                            Effect of foreign    Year over year growth on
September 30, 2012      Year over year growth exchange movements constant exchange rate basis
International net sales         5.7%                (1.8)%                   7.5%
Year to date ended                            Effect of foreign    Year over year growth on