IDEX Online Research: Blue Nile Continues to Surprise Us

Once again, Blue Nile surprised everyone. The company’s second quarter results were smoking. Supporters were in awe of its results, and skeptics can’t understand how the company can continue to post dramatic sales gains and capture market share.

It wasn’t that Blue Nile had easy sales comparisons against last year. In fact, sales in the second quarter a year ago were up 29.9 percent, the largest gain of any quarter in 2006. Profits were under pressure in the prior year due to a change in retail pricing strategy, so profit comparisons this year were relatively easy. Even so, the company posted a pretax profit margin of 8.1 percent in the three months ended June of this year, flat with last year. That’s for a three-month period when most jewelers lose money. Further, it is a profit margin that most jewelers don’t ever attain except perhaps in December.

Blue Nile’s Sales Surging Above Industry Averages

Industry wide, jewelry sales trends are mixed in the U.S. Guild jewelers’ sales remain relatively robust, but mass market jewelers are having a tough time capturing sales. It appears that U.S. jewelry sales will rise by 4 percent or more this year. Blue Nile, however, now expects its annual sales to rise by about 25 percent in 2007; earlier this year, the company was expecting a 20 percent increase in sales. In addition, it is likely that Blue Nile’s gross margin will rise, in contrast to most specialty jewelers who continue to experience deteriorating margins.

What’s driving this dramatic performance? How is Blue Nile distancing itself from most of its other online competitors and taking market share from traditional specialty jewelers in America?

Second Quarter Results Summary Shows Strong Performance

The table below summarizes Blue Nile’s financial results for the second quarter ended June 2007; below the table are some facts behind Blue Nile’s second quarter performance.

• Sales up sharply – Revenues in the second quarter ended June 2007 were $72.1 million, up 26.7 percent over the same quarter in the prior year.
• Average ticket flat – The number of orders rose by 27.2 percent to about 44,200 transactions in the second quarter. The average ticket was down very modestly at $1,630. That compares to the average ticket for a mass market jeweler of about $350 and a guild jeweler of $850 in the U.S.
• Non-engagement merchandise sales strong – Blue Nile’s management noted that demand for all categories of its merchandise were strong, though non-engagement jewelry was strongest. It cited particularly strong sales for wedding bands, earrings, pendants, and necklaces, as well as sterling silver jewelry. Based on this increased mix of lower ticket goods, we are surprised that the average ticket held almost flat with the prior year.
• High website traffic – Management also reported that its website traffic was the highest since mid-2004. This implies that the conversion rate may have fallen slightly, but that is to be expected, since much of the website traffic was probably new and of lesser quality in terms of its willingness to purchase.
• Repeat business very strong – Management said that business from repeat customers and referrals was very strong.
• Growth in mature market solid – Blue Nile reported that its sales growth in more mature, highly penetrated markets such as San Francisco grew at a rate of 20 percent or more in the quarter. Sales in less mature markets grew well in excess of the company average of 27 percent in the quarter.
• One sale of $1.5 million – Management reported that it made one sale of $1.5 million to a repeat customer in the quarter. If the impact of this single order is removed from Blue Nile’s average ticket calculation, its average sale in the second quarter would have been $1,594, or less than 3 percent below last year’s level. Again, the modest decline in the average ticket is due to a change in sales mix toward lower ticket non-engagement merchandise.
• Colored diamonds – Blue Nile is now selling colored diamonds, but it is only a tiny portion of its total business.
• International sales – International sales were $3.0 million; that’s less than 5 percent of total revenues for the quarter. However, this business is growing and could become meaningful in the future.
• Gross margin up – For the quarter, Blue Nile reported a gross margin of 20.7 percent versus 19.9 percent last year. If a one-time credit is removed, the “real” gross margin was 20.4 percent, up 50 basis points from the same period a year ago.
• Mix shift helped – A sales mix shift away from low margin engagement diamonds and toward non-engagement merchandise which carries an inherently higher gross margin helped boost the company’s reported gross margin in the quarter.
• One-time credit helped – The company booked a one-time credit related to shipping charges.
• Large sale hurt – If we assume that the single $1.5 million sale of a diamond was made at a 10 percent gross margin (a generous assumption, in our opinion), Blue Nile’s gross margin was probably depressed by 25 basis points or so in the quarter. In other words, the company’s gross margin would have been up another 25 basis points to 20.95 percent, more than 100 basis points higher than last year, if this large diamond sale had not occurred.
• Pricing strategy results in lower margins – In an effort to drive traffic and sales, Blue Nile reduced its prices on diamonds in the first half of 2006. At the time, this move cut into its gross margin by about 200 basis points.
• Operating expense ratio up modestly – Blue Nile’s operating expense ratio (expenses as a percentage of sales) was 13.7 percent in the quarter, up very modestly from last year’s 13.6 percent. If the impact of the incremental costs related to non-cash stock compensation is removed, operating costs would be lower as a percentage of sales on a year-over-year basis.
• Pretax margin flat – Blue Nile’s pretax margin was 8.1 percent of sales in the second quarter ended June, flat with last year. However, due to a higher tax rate, its net margin (after taxes) was 5.2 percent versus 5.5 percent last year. Total after-tax profits were $3.8 million, up from last year’s $3.1 million.
• Balance sheet remains very strong – Blue Nile’s cash position rose in the quarter, both from last year’s levels and from first quarter levels. The company’s annualized inventory turn was 15.6 times, dramatically above the typical specialty jeweler who reports a 1.0 annual inventory turn (0.7x if memo goods are included). Blue Nile has no short or long term debt. Its current ratio is a comfortable 1.9:1, and its vendor float is 290 percent (meaning that it payables are almost three times the value of its inventory).

Outlook: Bright & Sparkling

The outlook for the balance of 2007 brightened after the close of the second quarter. Management made the following comments about its outlook for the year:

• Sales stronger; profits up – Earlier this year, the company was projecting sales of $295-305 million; it now foresees sales of $312-318 million for the year ending December 2007, an increase of 25 percent over the prior year’s $252 million. Profits will likely grow faster than sales.
• Gross margin up – For the most recent fiscal year ended December 2006, Blue Nile’s gross margin fell 200 basis points to 20.2 percent due to a new pricing strategy. We now expect that the company’s gross margin in 2007 will exceed last year’s gross margin. This is counter to the industry trend; most specialty jewelers are posting a declining gross margin.
• Sales capacity up – The company’s new fulfillment center will expand capacity to “near $1 billion in sales,” according to management. If Blue Nile had achieved $1 billion in sales last year, it would have had about 1.5 percent market share of the U.S. jewelry market.
• Strictly a jewelry brand – Management said that it expects to focus solely on fine jewelry sales; it does not expect to expand the Blue Nile brand beyond jewelry.

We Aren’t Hyping Blue Nile; We Are Hyping Their Financial Model

Some in the jewelry industry have accused us of hyping Blue Nile. We own a token 100 shares of Blue Nile stock (we own 50-100 shares of every public company we write about, since it allows us access to shareholder-only information and events).

We aren’t hyping Blue Nile; we are, however, hyping the company’s financial model. It is not realistic to suggest that store-based jewelers will ever achieve the sterling financial results that Blue Nile is posting. It is important, however, that store-based jewelers understand that they can make money with memo inventory; they can turn their inventory more than once a year; and, they can post stellar profit margins, even during seasonally weak quarters. Any jeweler who tries to deny that it is possible is simply not facing reality.