(IDEX Online) – Blue Nile’s president Diane Irvine recently took the fall for the company’s recent challenges: weak U.S. sales trends, disappointing financial results including shrinking margins and rising expenses as well as loss of market share.

 

The key question is this: has Blue Nile hit a peak, or is this merely a pause in an otherwise long-term growth situation that a new CEO can fix?

 

One Billion in Sales?

Blue Nile was once touted as a company that was quickly headed for $1 billion in revenues. While its international sales are growing rapidly because the company is in the very early stage of tapping overseas markets, annual sales in the U.S. have stagnated around $300 million for five years.

 

Source: Blue Nile

 

For sure, the company had done a lot of things right:

 

·         As a pioneer in the jewelry segment – 12 years and counting – it has avoided the dismal fate of almost every other pioneer online jeweler from the 1990s and early 2000s: going bust. It is only one of a small handful of online jewelers who are still around, while dozens have gone out of business.

 

·         Blue Nile has shaken up the archaic jewelry industry business model. It has prodded jewelers to come into the 21^st century, and it has set the bar for the online jewelry business. It has proven to jewelers that by taking a shorter margin and increasing inventory turn, a lot of money can be made.

 

·         It has shown that its operating model can be exported into the international market place.

 

Blue Nile has also exposed some vulnerabilities of the online jewelry business:

 

·         Its use of consignment diamonds – buying diamonds at today’s prices to fill today’s orders, rather than stockpiling diamonds – works well in an environment of stable or falling diamond prices. In today’s diamond market, where prices have risen – a trend that is expected to continue over the long term – Blue Nile is not nearly as competitive.

 

·         Online jewelry is all about price, price, price. While Blue Nile’s customer service and selection is better than many specialty jewelers, online shoppers ultimately demand sharp prices.

 

Third Quarter 2011 Results Add to Worrisome Trends

In the third quarter of 2011, Blue Nile reported what it termed as “record” sales levels. This is a correct statement, but in context, its financial results were disappointing.

 

·         Blue Nile’s third quarter sales were up by 11 percent. International sales were up 55 percent (46 percent on a constant currency basis). But sales in its core U.S. market – just over 80 percent of total revenues in the quarter – were up a paltry 4 percent. This compares to a jewelry industry sales gain of 13 percent for jewelry sold by all retailers (specialty retailers posted a stronger 16 percent sales gain in the third quarter), and an estimated 15 percent sales gain for all online jewelers, as reported by comScore. Clearly, Blue Nile lost market share to both store-based jewelers and to other online jewelers.

 

·         Blue Nile’s unit sales of diamond engagement rings were down in the third quarter, based on our analysis. Further, our research suggests that unit sales were down more than the modest decline in marriages. While it is difficult to track marriages on a month-to-month basis – official government statistics run about a year behind – we believe that Blue Nile has lost margin share to other merchants – either online sellers or, more likely, store-based retailers – who sell diamond engagement rings.

 

·         Blue Nile’s average ticket fell in the third quarter, though neither management nor legal filings disclosed the size of the decline. Arguably, the decline in the average ticket is partially attributable to the increase in sales of non-engagement (lower-ticket) jewelry. But other jewelers, including some of the large publicly held retailers, have reported an increase in the size of their average ticket. Blue Nile’s average ticket trends seem to run counter to overall trends in the jewelry industry.

 

·         Blue Nile’s gross margin fell to 19.8 percent, a sharp decline from last year’s 21.7 percent. Most of the margin decline was due to a sales mix shift toward higher-priced, but lower-margin diamonds. However, the company also said that it sharpened prices – especially in the face of rapidly rising diamond and precious metals prices – in an effort to give its customers better value. Two factors bother us about this:

 

o   Blue Nile’s value proposition is already strong: it generates a gross margin in the 20 percent range versus the typical specialty jeweler’s 45-50 percent gross margin. Management cited examples of soaring diamond prices, up by as much as 40 percent in some cases. The IDEX Online Polished Diamond Price Index confirms this occurred with highly popular one-carat stones between January 2008 and mid-2011. But a fairer comparison is over a one-year span, since store-based jewelers turn their inventory about once a year – and that’s who Blue Nile competes against. The IDEX Index shows that one-carat diamond prices peaked at a 23 percent gain, year-over-year, in mid-2011 versus mid-2010. Our conclusion: Blue Nile did experience some margin pressure, but not to the degree implied by management’s statements.

 

o   The sales mix of non-engagement jewelry – with inherently higher margins – has been growing. This should have helped offset some of the margin decline in the diamond engagement category. Management was asked about this, but their answer dodged the question, in our view.

 

·         Blue Nile’s operating cost ratio rose significantly in the third quarter – 16.0 percent of sales versus last year’s 15.4 percent – mostly due to higher marketing costs. We can’t argue with investing in marketing, but when coupled with other worsening financial ratios, it does suggest a negative trend.

 

·         Blue Nile’s inventory levels are up more than expected, mostly due to an increase in non-engagement jewelry. Fashion jewelry is rarely available on a consignment basis, so the company must own the inventory in this segment of its business.

 

·         Our sense was that we did not get a full view of Blue Nile’s third quarter performance, either from its press release, legal flings or conference call. It is the company’s choice to put a positive spin on its operations, but as a former Wall Street analyst, we prefer the good, the bad and the ugly.

 

The Long View

Blue Nile has overcome some fundamental challenges, including the following:

 

Management Longevity – When it comes to Diane Irvine, we extend kudos to her. The management team who starts a retail company – as she did with Mark Vadon – usually lasts only until the retailer reaches $50 million or so in revenues. Then, another management team takes the company to the next level - around $200 million or so. The next team can sometimes take the company to $1 billion. The point is this: most (but not all) individuals have a limited scope of ability: start-up people are good with start-ups, but usually can’t run a big, well-oiled machine. It’s not in their genes. To Diane: congratulations for lasting as long as you did!

 

Pioneering Success – Pioneering companies often don’t last. Blue Nile has beaten the odds. The obituaries for online retailers are a long, long list. Most pioneering companies don’t know how to “move to the next level.”

 

Online Market Share

A key question is this: how much market share – in terms of retail sales – can online retailers capture?

 

Before you answer “all”, let us cite some historical data.

 

·         At their peak, catalog retailers – from Montgomery Ward, Sears, Sharper Image, Lillian Vernon, L.L. Bean, and others – held just over a 2 percent market share. If electronic media (mostly television) sales are added, total non-store sales in the 1990s peaked at about 3 percent of total retail sales. In other words, 97 percent of all retail sales continued to take place in a store. Catalog retailers offered many of the same competitive advantages of today’s online merchants, but in roughly one hundred years of existence, they were able to capture no more than 3 percent of total retail sales.

 

·         Based on the latest data, online retailers have captured about 4.6 percent of total retail sales in the U.S. Online jewelers have been somewhat more successful – they have an estimated 6 percent of total jewelry industry sales because they sell mostly big-ticket jewelry like diamond engagement rings. In short, 94 percent of all jewelry sales are still made in a store – either at a specialty jeweler or at a general retail merchant.

 

Stores Will Always Exist

We usually don’t make statements that contain the words “always” and “never.” But we believe that retail stores will always exist.

 

There are prognosticators who suggest that as today’s tech-savvy consumer ages, more Americans will shop online. We don’t dispute this, but we believe that it is unreasonable to suggest that a large percentage of retail sales will ever be made online.

 

To understand our point of view, you need to understand why people shop:

 

·         To Buy Things – People shop to buy things. They can do this in a store, on line, from a catalog, at a shopping party, or via a variety of other distribution channels.

 

·         To Socialize – People like to go out to see and to be seen. People meet their neighbors at the store. There’s nothing new about the social need of shoppers: the Agora (shops) existed in ancient Athens at the foot of the Acropolis thousands of years ago. Socializing online – even with Skype – isn’t the same as socializing in person.

 

·         For Recreation – Americans probably invented recreational shopping. “Let’s go to the mall” is a familiar refrain in the typical American household. Malls have movie theaters, game rooms, and other recreational pursuits. There are ample recreational opportunities online, but sometimes you get “cabin fever” and you need to leave the confines of your home for recreation.

 

·         To Touch & Feel – Shoppers like to touch and feel the merchandise before they buy it. While a book is a book, many merchandise categories are not created equal: some clothing is better made than other clothing, and some jewelry sparkles more than other jewelry. You can’t tell the difference until you handle the goods. Further, Americans take ownership of goods once they are in their hands. A smart jeweler knows to put the diamond bracelet on the customer’s arm, rather than simply laying it on the sales counter. Once that bracelet is on the woman’s arm, it rarely comes off. You can’t touch and feel the goods at an online shop.

 

·         Americans Are Extroverts – Research varies, but in general, it shows that a majority of Americans are extroverts. Extroverts simply do not get their “shopping jollies” sitting in front of a computer screen.

 

The Internet Did Not Create New Consumers

Retailing is a sum-zero game. Online shoppers do not represent new consumers or a new market; retailers are simply reaching existing shoppers with a new distribution channel. There are no new consumers and virtually no new sales as a result of the internet. How do we know? Simple: there has not been a change in population growth since the internet was created (read: “no new consumers”), nor have the government’s printing presses increased their capacity to print more money since the internet was created.

 

Conclusion: A Peak for Now, But Opportunities Abound

We wish Blue Nile well; we never bad-mouth a company. Blue Nile is doing all of the right things to build its business, both in the U.S. and overseas. But as they say, “the low-hanging fruit” has been picked in the U.S. market.

 

Blue Nile’s bridal engagement business will likely continue to grow in the U.S., but at a moderate single digit pace. Its non-engagement business holds much potential, but non-engagement jewelry is bought differently from engagement jewelry (the dynamics of demand are very different – and too complex to discuss in this article). It remains to be seen if consumers will embrace Blue Nile for a significant level of their non-engagement, fashion jewelry needs.

 

Blue Nile’s international business offers much opportunity, and it will likely drive top line revenue growth for many years. But, it, too, will have a peak.

 

We aren’t saying Blue Nile’s sales won’t reach $1 billion. But we are saying it will take a lot longer than anyone thinks.