Blue Nile appears to have captured over 4 percent of the total diamond engagement ring market in the U.S., based on preliminary estimates for 2007. That’s quite an accomplishment for a company that has been in business less than ten years.

 

Furthermore, it is surprising that an online merchant has been able to make such strong inroads into a business that has traditionally relied on romance and emotion as a major component of the engagement ring purchase process.

 

The other big news at Blue Nile is that its growth rate has apparently come to a heart-stopping halt in the first quarter of 2008. “Customers are behaving differently,” commented Blue Nile chairman Mark Vadon. They aren’t searching online for jewelry at the same pace as in the past, and the upgrade engagement ring business has all but dried up at Blue Nile. Furthermore, some newly engaged couples are putting off purchasing an expensive diamond engagement ring, perhaps opting instead to buy a less expensive colored gemstone ring with plans to upgrade later.

 

First Quarter Sales Likely to Be Flat

Acknowledging that its forecast is conservative, Blue Nile management said that the company’s first quarter “net sales are expected to be relatively flat with Q1 2007.” We think that they will likely post a single digit gain for the three-month period. Profits in the period will be diminished from the prior year.

 

The graph below illustrates recent quarterly sales progression – percent change year-over-year – for Blue Nile. The far right bar shows 0.0 percent change – the forecast for Blue Nile’s first quarter of this year.

 

Source: Company reports

Let’s be sure we understand what is happening at Blue Nile: the company is doing just fine. It expects to post first quarter sales of at least $68 million, about flat with last year, for virtually no sales growth. That is what is important to understand: sales growth is on hold. Frankly, many store-based jewelers wish they could say the same thing, since an alarming number have reported a substantial decline in their sales year-over-year through February, including the important Valentine’s Day selling period.

 

If Blue Nile’s full year sales in 2008 are flat with 2007, the company will still post the equivalent revenues of about 320 independent specialty jewelers, and it will rank as either the 6th or 7th largest specialty jeweler in the U.S. in 2007, based on preliminary estimates.

 

What are the factors behind the company’s conservative forecast?

 

• “Consumers are behaving very differently in the past ten weeks,” commented Chairman Mark Vadon, referring to December, January and first half of February. He noted that the number of people searching for jewelry online has diminished; people simply aren’t in the market. That is the same trend that store-based jewelers have experienced recently: there is less customer traffic in the malls.

• Price points above $25,000 retail have suddenly gotten very weak at Blue Nile. Historically, the high end of the market remained robust in a recessionary environment. “Old wealth” traditionally kept spending, without regard to the economic cycle. However, because a large number of wealthy households now represent “new wealth,” they behave differently when the economy slows. We estimate that nearly half of the households earning over $100,000 annually are newly wealthy families.

• The upgrade engagement ring business has nearly evaporated. Upgrade engagement rings – second ring, same wife – traditionally carry very high price points, often $50,000 and higher. This business has nearly dried up.

• Newly engaged couples are putting off the purchase of a diamond engagement ring. Apparently, many of these young couples are opting for a less-expensive colored gemstone ring, with plans to upgrade later.

• Comparisons against last year are difficult. In last year’s first quarter, the company posted a 34 percent sales increase, the largest quarterly gain in three years.

• A major marketing promotion has been eliminated. Last year, Blue Nile worked with Google, using a “$$-off” coupon to drive traffic. Blue Nile isn’t repeating that promotion this year.

• The company has no plans to slash prices to try to drive demand. Mark Vadon is smart: in this current sluggish retail environment, cutting prices only yields lower margins, not more sales.

• These negative factors will be somewhat mitigated by growth in the company’s international business. For the full year 2007, international sales were $17 million, driven by the launch of two major markets – Canada and the UK. As this business begins to mature, sales should ramp up quickly.

Other Financial Highlights from the Fourth Quarter and Year

Other highlights from the company’s fourth quarter and full year include the following:

 

 

• Blue Nile’s average ticket for a diamond engagement ring in 2007 was $6,200, up from the prior year’s $5,700. This is well above the industry average of $3,210 (2006), but more in line with the average ticket for a diamond engagement ring at a guild (AGS-type) jeweler.

• Blue Nile’s average ticket in the fourth quarter was $1,411, up 7 percent from the prior year. Furthermore, its conversion rate was up (browser-to-buyer).

• Despite a slowdown in demand for high-ticket goods late in the year, Blue Nile said its sales of jewelry priced over $25,000 were up 50 percent for the full year.

• About 69 percent of the company’s $319 million in annual sales came from engagement rings. Based on the average ticket, a “back of the envelope” calculation shows that Blue Nile sold over 35,000 diamond engagement rings in 2007. If an estimated 2.2 million couples became engaged, and 75 percent of them received a diamond engagement ring, we calculate that Blue Nile captured just over 2 percent of the engagement ring market in units, and over 4 percent of the market based on dollar sales.

• The company continues to note that its best source for sales is referrals and repeat customers. Far too many store-based specialty jewelers don’t understand this. As a result, they miss out on much business. Blue Nile touts its competitive differential as selection, value and customer service.

• Management said its long term goal for the company’s operating cost ratio is 10.0 percent of sales; last year, it was 11.6 percent. A traditional store-based jeweler has an operating cost ratio of around 40 percent (excluding interest and non-cash charges such as amortization). Because Blue Nile neither has high fixed costs nor is asset-intensive, its operating costs are inherently lower.

• Despite the heavy use of memo, Blue Nile was able to extend its “days payables” by four days. It ended the year in an over-inventoried position, but there is little product risk, since most of this inventory consists of settings and bands. Management won’t return those goods to its vendors, because it bought them when precious metals costs were much lower. Blue Nile has virtually no long term debt, and it is awash in cash.

• The company has incurred additional operating costs related to stock compensation, lower interest income, higher expenses associated with its new distribution center, and higher marketing costs.

Full Year Outlook Calls for Modest Sales Growth; Profits Down

Management of Blue Nile provided its view for the year of 2008:

 

• Net sales are expected to grow by a very modest 10 percent. This would be the smallest gain in the company’s short history. However, this growth rate is about four times our projected preliminary growth rate for all jewelry sales in 2008.

• Earnings per share in 2008 are expected to be about flat with 2007. However, this assumes that the company will have fewer shares outstanding. Thus, 2008 net profits are expected to be lower than 2007’s levels.

This forecast speaks volumes to the jewelry industry: even high-flyers such as Blue Nile are feeling the impact of retracted consumer spending on discretionary items such as jewelry.