Tuesday, May 22, 2007

Is the Luster off Blue Nile?

The French are glad to die for love.
They delight in fighting duels.
But I prefer a man who lives
And gives expensive jewels.

Blue Nile (NILE-$52.50) recently reported net sales of $67.9 million in the first quarter, representing year-over-year growth of 34 percent. The increase in net sales was attributable to strong growth in all product categories.

A kiss on the hand
May be quite continental,
But diamonds are a girl's best friend.

The online diamond retailer delivered net income of $3.2 million, up 34.3% from the first quarter of 2006. Reported net income per diluted share was $0.19, representing EPS growth of 46 percent. Our EPS of $0.19 for the quarter was $0.04 above the top end of our guidance range.

Analysts expected $0.15 a share on $62.1 million in net sales.

Men grow cold
As girls grow old,
And we all lose our charms in the end.

CFO Diane Irvine said, “Few companies know their customers as well as we do, and this allows us to continually become more adept at tailoring our website and our products to answer our customers' needs. This is visible through the healthy increases in the volume of traffic to our website, as well as our conversion rates during Q1. Total orders increased over 29% as compared to a year ago. Our average selling price per order was $1,536 in the first quarter, representing an increase of 3.6% from the prior year.”

As if to lend legitimacy to their business model, CFO Irvine enthusiastically crowed about the performance of jewelry at price points above $25,000: “The number of orders at price points above $25,000 increased 69% from the prior year. In diamond jewelry, we had seven transactions above $100,000 during the first quarter.”

CEO Mark Vadon added that Blue Nile was rapidly evolving into a brand of class—an e-tailer Tiffanys, "Stature of the Blue Nile brand is such that so many people trust us with such exceptional purchases. Some of the most impressive sales this quarter included a 5-carat engagement ring for $140,000 and a 6.5-carat pair of diamond earrings for $130,000. Our most memorable order during the quarter was a $195 garnet pendant that was shipped to a customer in Texas in late March."

But square-cut or pear-shaped,
These rocks don't loose their shape.
Diamonds are a girl's best friend.

When asked by an analyst about the impact of price point activity on margins, Vadon did concede there was a trade-off, growth rate for downward pressure on margins—above $100,000 gross margin fell to the single digits.

Albeit unit volume and unit prices increased, gross profit as a percentage of net sales was 19.5% in the quarter ended April 1, down 90 basis points from the prior year. Management said the decrease in gross profit as a percentage of net sales was primarily due to retail price reductions in diamonds that were instituted midway through the quarter ended April 2, 2006 to optimize gross profit (euphemism for saying that price-cuts were initiated on some products to stimulate—otherwise—sluggish sales?) In our view, higher diamond prices from suppliers adversely impacted gross margin, too.

Operating income as a percentage of net sales increased 20 basis points in the quarter to 5.4%, due to higher volume sales and a 100 basis point reduction in SG&A (which management attributed to their ability to “leverage the cost structure”).

Blue Nile has historically spent about 4 percent of revenues on marketing and advertising, a level that management says will continue for the foreseeable future. This is slightly lower than the typical independent specialty jeweler who spends about 5 percent of sales on promotions and advertising. Tiffany & Co. spends about 6.2 percent of revenues on advertising. Contrary to management’s view, we believe SG&A will come under pressure in future quarters.

The Company is looking to expand internationally, which means a build-out its infrastructure—fulfillment operations and electronic commerce services.

On the conference call, CFO Irvine said, “all categories were very strong…. Wedding bands are tremendous, probably our number 2 product category. Then if you look at non-diamond jewelry, we had great growth there. Sterling silver performed incredibly well, great growth during the quarter.”

Yet, in its 10Q regulatory filing, Blue Nile commented that net sales and results of operations were still highly dependent on the demand for diamonds and diamond jewelry, particularly engagement rings. In fact, more than 90% of business is still in diamonds, 70 percent being in engagement rings. In order to increase net sales and expand its product offerings, the Company must attract new customers or expand returning customers’ product purchases in a cost-effective manner.

Blue Nile’s growth strategy is to communicate its ‘value proposition’ (offering certified diamonds at up to 40% off retail prices) to visitors of its online site. In the last two years, Blue Nile proved to have the highest online visibility of any jewelry retailer across paid and organic search listings. Management attributes this success to its continued web site innovations, including its interactive
diamond search.

In our view, the online jewelry market is not as fragmented as when Blue Nile was first-to-market five years ago. Brick & mortar jewelers are narrowing the gap, investing more to increase search engine visibility. In addition, by building their own interactive resources, competitors are making it as easy for their customers to browse their websites as it is to walk through their doors.

Black Starr!
Frost Gorham!
Talk to me Harry Winston.
Tell me all about it!

Tiffany & Co., home of the little blue box that sets womens’ hearts aflutter, does not offer diamond engagement rings for sale online, it now offers an interactive section that educates diamond buyers in the 4 C’s of diamond quality and the ability to schedule an in-store consultation. The 10Q Detective notes that products containing one or more diamonds of varying sizes accounted for only 46 percent of Tiffany & Co’s net sales in Fiscal 2006.

As Blue Nile looks to other drivers, such as silver jewelry and smaller ticket diamond jewelry in an effort to reach new customers, the Company will start bumping into formidable online competition from the likes of a Tiffany & Co or a
Kay Jewelers.

To avoid maturation of paid-search and stay competitive in diamond search functionality, Blue Nile will have to pony up more advertising and marketing dollars, which will probably increase the cost of a new customer. [The Company does not currently release what it costs to convert a browser to a buyer.]

In addition, we believe that the build-out of online sites by stores with a national footprint—brick and mortar or direct merchandisers—will adversely impact future growth of repeat and referral revenue at Blue Nile. The budget-conscious consumer, for example, can now find an engaging ‘Design Your Own’ diamond service at national retailer
Zales .com site.

There may come a time
When a lass needs a lawyer,
But diamonds are a girl's best friend.

In support of our argument, we submit evidence from Alexa, which provides information on web traffic to online sites. The daily traffic rank (based on a combined measure of page views and users reach) of Blue Nile is trending lower, peaking at a 1,100 rank during the Christmas 2004 holiday (which means there were only 1,099 sites more frequently visited at that time). Its current 3-month average Alexa traffic rank is 10,150.

[Ed. note. We acknowledge the critics of Alexa, who contend that the representative Alexa's user base is atypical of actual Internet behavior.]

Bulls argue that Blue Nile is unstoppable. Future growth will be driven by further penetration in existing markets and new growth in other jewelry categories. Whereas the Company has had success in leveraging online commerce, our aforementioned presentation suggests that the Company’s formula for success in diamonds may not translate into similar success for other jewelry categories.

Looking ahead, Blue Nile sees full-year earnings of 86 cents to 91 cents a share, up from a prior guidance of 80 cents to 85 cents. Blue Nile projects sales of $295 million to $305 million, compared with its earlier forecast of $290 million to $300 million.

Wall Street predicts full-year earnings of 86 cents a share and sales of $300 million.

He's your guy
When stocks are high,
But beware when they start to descend.

On a risk-reward basis, the current valuation of Blue Nile is not compelling. The common stock is selling at 61.6 times fiscal 2007 consensus earnings’ estimate—or a premium of more than 3 times forward 12-month peer estimates. The stock price discounts any fundamental acceleration (even hitting the top-end of its share-net guidance).

Time rolls on,
And youth is gone,
And you can't straighten up when you bend.

While we believe that management is committed to improving its product strategy, it has not yet executed on attracting broader customer appeal for non-diamond products. Product newness will require (unacknowledged) additional marketing dollars.

I don't mean rhinestones!
But diamonds are a girl's best friend.
-- "Diamonds are a Girl's Best Friend" (GENTLEMEN PREFER BLONDES, 1953)

Perhaps this elevated execution risk is the unspoken rationale why insiders—who beneficially own 2.3 million shares of the common stock outstanding—have unloaded more than 16.3% of their holdings, for an estimated $20.0 million.

Marilyn Monroe may have sung,
Diamonds Are a Girl's Best Friend”, but like this (highlighted) Swing Cats version, it lacks the luster of the original. The same can be said for Blue Nile trying to remix its business strategy

Editor David J. Phillips owns put options in Blue Nile's common stock. The 10Q Detective has a Full Disclosure Policy.


Leeza said...

As if to lend legitimacy to their business model, CFO Irvine enthusiastically crowed about the performance of jewelry at price points above $25,000:
too expensive

Erez Rothem said...

Excellent article,
Thanks for sharing.