Sometimes GAAP accounting obscures reality. That’s what happened at Blue Nile when it reported its financial results for the fourth quarter and year ended December 2006. Although it appears that profits were essentially flat in the fourth quarter and for the full year, the reality is that the company posted a 23 percent increase in net profits for the three months ended December 2006, and a 19 percent increase in net profits for the full year 2006.

 

Both GAAP (Generally Accepted Accounting Principles) and the regulators required Blue Nile to report that its annual profits were $13.1 million in 2006 versus $13.2 million in 2005. Unfortunately, these numbers are not comparable. What’s worse is that both GAAP and the regulators claim that the new accounting principles bring increased transparency to publicly held companies.

 

What neither GAAP nor the regulators apparently foresaw was the impact on reported results during the first year of implementation of the new accounting requirements. In the case of Blue Nile and others, the impact is quite simple: year-to-year results are not comparable, yielding potentially misleading information for investors, the media, and other interested people.

 

What makes things even more complicated about Blue Nile’s year-end financial press release is that it appeared to report flat net income, but its earnings per share – a major financial benchmark for investors – were up.

 

With any modest amount of digging through the numbers, investors could have come to three different conclusions about Blue Nile’s profits: 1) they were flat as reported on a non-comparable basis; 2) they were up somewhat based on earnings per share; or, 3) they were up sharply, based on an apples-to-apples non-GAAP comparison.

 

Who’s Correct?

In our 20 years on Wall Street, our primary task was to cull through a company’s numbers, financial filings, and legal briefs to determine what the “true” state of the company was. Quite often, we had to take issue with the accountants who dream up new financial regulations. Unfortunately, most of those accountants are far too removed from reality to understand the impact of their decisions on the day-to-day financial operations of a company.  

 

One quick look at Blue Nile’s fourth quarter and full year financial results told us that the reported numbers were not comparable year-over-year.

 

The company went to great lengths in its financial press release to explain new GAAP requirements and the impact on results. Unfortunately, many readers probably should have had an accounting degree to understand what management was trying to say. It wasn’t that management’s explanation was poor; rather, the explanation is technically complicated, and we sense that many people got glassy-eyed trying to understand the explanation. Further, lawyers were likely also involved in the drafting of the press release, and we know how they can take some simple and make it complicated. So, readers of the press release simply skipped the relevant sections which, in fact, provided a full explanation of the financial results as well as why and how each year’s results were calculated and could be made comparable.

 

Comparable Results

Forget everything you’ve read elsewhere in the media. Here are Blue Nile’s actual results, which reflect reality and are not encumbered by new GAAP pronouncements.

 

Source: Company reports and IDEX Online analysis

 

Other Highlights of the Quarter and Year

 

• With $252 million of sales, Blue Nile has captured about 10 percent market share of the online jewelry market, estimated by both Jupiter and the U.S. Department of Commerce to have been about $2.45 billion in 2006. Based on preliminary figures, online jewelry commerce in the U.S. represented about 3.9 percent of total jewelry sales. Further, based on a typical specialty jeweler’s sales per store of about $1.1 million in 2006, Blue Nile’s 2006 sales represented the equivalent of about 229 jewelry stores.
• Blue Nile’s average ticket for the fourth quarter was $1,314, up 2.3 percent from last year’s $1,284. This is far above the average ticket for both mass market jewelers (around $350) and better-end guild jewelers (about $750).
• Total orders rose by 21 percent in the fourth quarter. Traffic to Blue Nile’s website was up double digit levels, and the conversion rate (browser-to-buyer) also rose, according to management.
• Management described 2006 holiday sales as “fantastic.” They cited three categories that produced especially strong sales:

• Journey diamonds, especially pendants.
• Large, high-priced diamonds
• Sterling silver charm bracelets

• The company recorded 40 retail transactions in the fourth quarter above $50,000.

• Online selling is a procrastinators’ haven. Shoppers on the Internet know that they can wait until the last minute, and still receive their order in time for their needs. While store-based jewelers reported that their sales were strong early in the 2006 holiday selling period and then slowed late in the season, Blue Nile reported the exact opposite trend. Blue Nile’s sales came at a measured pace early in the season, and then surged in the final two weeks prior to Christmas. Management even suggested that the company may have lost some sales, due to overwhelming demand between December 9 and December 23.

• The company’s strategy of aggressive pricing on diamonds, which was implemented in the first quarter of 2006, was particularly successful in the fourth quarter. Not only were sales strong in the fourth quarter – up 24 percent – but this dramatic revenue gain provided substantial leverage for operating costs in the three-month period. On an apples-to-apples basis year-over-year, the company’s operating cost ratio in the fourth quarter was 10.4 percent of sales versus last year’s 11.8 percent of sales. Its gross margin fell to 20.6 percent from last year’s 22 percent. In other words, its gross margin decline of 140 basis points exactly offset its 140 basis point decline in the operating cost ratio. The bottom line post-tax profit in the fourth quarter rose by 23 percent, year-over-year, prior to one-time accounting adjustments.

• The company’s pretax margin for the year was 9.6 percent, more than double the typical independent jeweler’s pretax margin of about 4 percent, according to the Jewelers of America Cost of Doing Business Survey.

• Blue Nile’s annual inventory turn rose to an astounding 13.7 times, somewhat higher than last year’s 13.4 times turn. The typical store-based jeweler turns his/her inventory about 1 time or less per year.

• Overall advertising expenses are running at about 4 percent of sales, in line with historic levels.

• Blue Nile’s customer mix consists of about 20 percent repeat business and 80 percent new business. We expect that this ratio will begin to tilt toward repeat business as the company matures. In a bit of chest-thumping, management noted that its customer service quality index rose to 4.5 (out of 5) from 4.3 in the fourth quarter of the prior year. Further, management noted that it has cut the time to produce “custom” jewelry from three days to two days, in most cases. Further, management continues to tout its sales strategy – low prices and business transparency – as the way to reach new, younger customers in a non-threatening manner. In short, if these trends continue, happy customers are likely to continue to shop with Blue Nile and refer their friends.

• Management noted that its supplier terms remain in line with historic trends. It has supply agreements with diamond vendors with three-to-five year terms. Its payment terms on owned jewelry run 45-60 days, with extended payment terms of 120 days or longer with some vendors.

• At the end of the year, the company had just over $98 million of cash in the bank, after using cash of about $57 million to repurchase its shares during the year. Sales last year were $252 million.

• Its international sales – Canada and the United Kingdom – were just over $8 million last year. Fourth quarter international sales were $2.9 million, up 67 percent over the same period last year.

Outlook

Management gave its outlook for 2007, as follows:

 

• Annual sales – $290-300 million, up between +15 percent (if sales are $290 million) to as high as +19 percent (if sales are $300 million). At this rate, Blue Nile’s sales will represent about 270 independent jewelers, based on an average store’s sales of $1.1 million for 2006. This level of sales should push the company into the list of America’s top ten specialty jewelers, by revenues.
  
  We also note that the company’s pace of sales growth is slowing, as expected. It added roughly $50 million in revenues to its sales base in 2006; management expects to add another $40-50 million in revenues in 2007. However, as the sales base growth, the percentage gain becomes smaller.

• Management gave its profit forecast for the year on an “earnings per share” basis. Depending on various assumptions, it appears that profits, expressed in millions of dollars, could be up in the range of 10 percent or so, significantly below sales gains. If this is true, then it is clear that management has wrung most of the efficiencies out of its operating cost ratio. Further, management has an item of $1.8 million in its capital expenditure budget for the expansion of its fulfillment center; that could add significant one-time incremental costs in 2007. Management said that it would continue to be aggressive with its diamond pricing, though as the mix of non-engagement jewelry rises, margins could increase. The bottom line: our sense is that management has issued a safe profit forecast for 2007.

• For its first quarter ended March, Blue Nile management is projecting sales between $61 and $63 million, an increase of 20 to 24 percent. This strong increase in sales is due to two factors: 1) roughly half of the first quarter – including Valentine’s Day – is already behind Blue Nile, so management has a good idea of how sales are going in the quarter; and 2) the company did not begin aggressively pricing diamond jewelry until sometime in the first quarter of 2006. Thus, the stronger demand that lower diamond prices generated in 2006 was not felt fully in the first quarter.