When Blue Nile reported its third quarter financial results for the three-months ended September, 2006, a couple of weeks ago, management noted that revenues were up nearly 27 percent, but the report on profits was cloaked in GAAP-speak that only accountants could understand. 

 

All of the technical talk about accounting changes, coupled with supplemental non-GAAP tables, obscured some of the more fundamental trends of the business that are generally positive, in our opinion.  IDEX Online Research has dissected the company’s earnings report, and here is ‘page two, the rest of the story’ about Blue Nile’s third quarter financials.

 

• Sales in the third quarter were $53.2 million, notably above the company’s plan of $52 million.  Sales in the third quarter of 2005 were $42 million.  Sales in this year’s third quarter were driven by a variety of factors, including the following:

• The average ticket rose to $1,884 this year from $1,773 in last year’s third quarter.  The average ticket was up due entirely to an increase in the sales mix of higher-priced fashion jewelry.  The average ticket for diamond engagement rings was flat at about $5,700, a level that is more than double the U.S. jewelry industry average of $2,750.

• IDEX Online Research thinks that it is notable that the average ticket climbed over 6 percent based on selling more higher priced fashion jewelry.  The typical average ticket for fashion jewelry for store-based retailers is in the $700 - 1,000 range.  Thus, it is clear that, like diamond engagement rings, Blue Nile’s average ticket for fashion jewelry, which includes diamond jewelry and other categories such as pearls, is also much higher than the industry average.

• The total number of orders was up 19.4 percent in the quarter. 

• Blue Nile noted that customers have been asking for larger, better quality diamonds.  In the third quarter, it sold one engagement ring for $324,000, perhaps the largest sale in the company’s eight year history.  However, management noted that its third quarter sales mix of small versus large stores was similar to other quarters, and that this single sale did not have a material impact on the average ticket for the period.  Management says it receives orders “daily” for engagement rings priced above $10,000.

• The company’s new pricing strategy also fueled sales.  During the first quarter of this year, the company reduced prices on its diamond jewelry.  While Blue Nile does not offer the lowest prices among online retailers, it offers an excellent value.  Gross margins have suffered as a result of its recently implemented pricing strategy, but the end result was more gross profit dollars.  Management noted that its margin on diamonds priced above $100,000 is in the single digit range.  It claims that it sells this high-priced diamonds to retail shoppers below the wholesale prices that most smaller, lower-volume independent jewelers pay. 

• Blue Nile targets tech-savvy markets such as San Francisco, Washington, and Boston.  In San Francisco, management says its market penetration, measured as sales per capital, is roughly the equivalent of $2 per person (based on the total population of the metro).  In under-developed markets, its penetration may be the equivalent of only $0.30 per capita.  In more mature markets, its sales mix is tilted toward fashion jewelry, since it generates much repeat business from satisfied engagement ring purchasers. 

• International sales in the third quarter were $2.2 million, up 259 percent.  Currently, the company has web sites targeting the Canadian market and the United Kingdom. 

• Blue Nile’s third quarter gross margin fell to 19.6 percent versus 22 percent last year, but its gross profit dollars rose nearly 13 percent to $10.4 million.  That extra $1.2 million of gross profit went toward paying operating costs.  In other words, the company has found the inflection point – also called the “kink” – in the demand curve.  By dropping prices enough to reduce margins by 340 basis points from last year, there was a substantial positive impact on sales which drove higher gross profit dollars.  This is the kind of financial scenario that economists talk about, but few companies truly understand, and even fewer are successful at implementing it.

• Blue Nile’s gross margin of 19.6 percent is well below most store-based jewelers, who operate with a 45-50 percent gross margin.  Blue Nile’s management says its goal is to sell jewelry to shoppers for about 30 percent less than a typical store-based jeweler.  Its numbers would indicate that it appears to have achieved this goal. 

• On an apples-to-apples basis, Blue Nile’s operating expense ratio fell to 13.3 percent of sales from last year’s 14.4 percent.  However, on a reported basis, it was 15.5 percent of sales, and this is where the accounting gets murky.  In short, the reported operating expense ratio included stock-based compensation this year, but not last year.  For jewelers, the important number to focus on is 13.3 percent.  That number is nearly 3000 basis points – yes, nearly 30 points – below the typical jeweler’s operating expense ratio in the 39-45 percent range.  Management’s goal is to take the company’s operating expense ratio down to about 10 percent of sales.  At that level, it is almost impossible for a store-based jeweler to compete on price with Blue Nile, especially if the store-based jeweler hopes to stay in business. 

• Because of Blue Nile’s operating model, it generates substantial cash flow.  Year-to-date, based on IDEX Online’s free cash flow calculation, Blue Nile has generated more than $7 million of cash – after paying for capital expenditures – to plow back into its operations. 

• The outlook for Blue Nile remains bright.  After experiencing slowing growth late in 2005 and early 2006, management apparently has the company back on a fast-growth track, based on its recent financials.  Its major online competition has more or less evaporated.  Odimo, one of the larger online jewelers, sold off its diamond business, and is only a shadow of its former self.  Others have experienced reduced sales levels. 

• Blue Nile has lined up new merchandise for the all-important 2006 holiday selling season, including sterling silver jewelry, pearls, and one-of-a-kind diamonds. 

• For the year, Blue Nile’s management is forecasting sales of nearly $255 million.  That’s the equivalent annual revenue of roughly 250 independent jewelry stores in America.  That could leapfrog this eight-year-old company to the seventh largest specialty jeweler in the U.S.  However, depending on annual revenues from Ben Bridge (currently the seventh largest specialty jeweler) and the “new” Whitehall Jewellers, Blue Nile could move up into the sixth position among all U.S. specialty jewelers. 

• For those privately held jewelers who still think they want to become a public company, take heed:  Blue Nile’s management said its costs related to Sarbanes Oxley were about 1 percent of revenues.  That’s one percent that flows directly to the pretax line; that’s one percent most jewelers can’t afford.