Like most retail jewelers in the U.S. market, Blue Nile, the largest online jeweler, is also posting weak sales results. Total sales were up a mere 2 percent to $73.3 million in the three-month period ended June, while sales in the U.S. market were down 5 percent to $65.6 million.

 

The company also reported a 15 percent decline in profit in the June quarter to $4.9 million (pretax). Two things strike us a notable about this: 1) the profit decline was only 15 percent, a very small decline given Blue Nile’s weak sales; and, 2) the company actually posted a profit, in contrast to most retail jewelers who do not post a profit until the fourth (holiday) quarter of the year.

 

The company tempered its outlook for the year. Management reduced its sales growth goal for 2008 to a “mid-single digit” level (about +5 percent) from its earlier guidance of about +10 percent.

 

The company also said that earnings per share for Blue Nile are expected to be about flat for the year versus the prior year. While this may be true, it needs interpretation, especially for people without a financial background. Because there will be fewer shares outstanding in 2008 versus 2007 due to an ongoing stock buyback program, it is clear that Blue Nile expects total dollar profits to be down this year, even though technically earnings per share could be roughly flat. Still confused? Here’s what this means: overall corporate profits are expected to be down for 2008.

 

Second Quarter Results Weak

Total revenues in the second quarter ended June edged up by a very modest 2 percent, driven totally by international demand.

 

In the U.S., Blue Nile’s sales were down about 5 percent. Four factors had a dampening impact on the company’s sales:

 

• Customers traded down to smaller diamonds. 

• The average ticket was down just over 5 percent, on an adjusted basis.

• Credit approvals were down. This had a major impact on sales of diamonds in the $5,000 to $50,000 range.

• Sharp increases in diamond prices hurt demand. Blue Nile has virtually no inventory of diamonds to help buffer retail prices. It buys diamonds in the spot market on a daily basis; thus, it pays higher prices immediately. In order to meet its margin goals, its retail prices must rise in line with its diamond costs.

There were some positive factors which helped to offset these negatives:

 

• Total orders were up 13 percent, on an adjusted basis.

• Customer traffic was up.

• The conversion rate (browsers-to-buyers) edged up slightly.

• Return rates were “steady to slightly down”, according to management.

Despite Blue Nile’s weak second quarter sales, we believe it gained market share in the diamond jewelry category. According to DeBeers Group Marketing, diamond jewelry sales were down 3 percent in the U.S. market in 2007; in 2008, we believe that diamond jewelry sales are down in the 6 percent-to-8 percent range year-to-date. Roughly 90 percent of Blue Nile’s sales are generated by diamond jewelry. Thus, Blue Nile’s sales decline of 5 percent - almost all diamond jewelry – is not as great as the estimated decline in overall diamond jewelry sales in the U.S. market this year.

 

The following table summarizes results for Blue Nile’s second quarter ended June, 2008.

 

Second Quarter Highlights

The following points highlight Blue Nile’s second quarter results.

 

• Monthly sales trends varied – Sales were up modestly in April and May, but down notably in June, when gasoline prices spiked. Management also disclosed that sales in July, the first month of the third quarter, were also weak.

• Credit approvals were down – Despite no significant change in its customers’ credit scores, Blue Nile’s third party credit provider approved fewer credit applications. Many of Blue Nile’s young, engagement-age customers have the potential for rising incomes, but they have no assets and, hence, no credit history. The company does not disclose the percentage of sales it makes on its proprietary credit program.

• Cost inflation hurt Blue Nile – Management noted that diamond prices were up 7 percent-to-25 percent, year-over-year, for Blue Nile. Larger diamonds posted greater price increases, it noted. This correlates with the IDEX Polished Diamond Price Index which shows that overall polished diamond prices are up in the mid-teen range, year-over-year.
  
  Because Blue Nile does not maintain any significant diamond inventory, it must buy diamonds daily in the “spot market” to fill its orders. As a result, diamond price increases hit Blue Nile first. With the spike in wholesale prices in late May – an artificially induced spike which has since moderated – Blue Nile was forced to increase its retail prices immediately. This led to slightly less retail price disparity between Blue Nile’s low online prices and a traditional store-based jeweler’s prices.
  
  Further, on a year-to-year basis, precious metals costs are up, though they stabilized in the quarter.

• U.S. sales declined by just over 5 percent in the quarter to $65.6 million versus $69.2 million last year – It is important to put these numbers in perspective: this indicates that Blue Nile posted the equivalent annual sales of roughly 325 traditional independent specialty jewelers in the quarter. Sales may be under siege, but Blue Nile is still a huge force in the market.
  
  Last year’s second quarter sales (2007) were driven by two unusual factors: 1) there was a single sale of a $1.5 million diamond; and 2) there was a special promotion with Google that generated a large number of low-ticket sales. The company did not disclose the full extent of these two unusual factors, but if they are removed, Blue Nile’s second quarter sales would have been greater this year than last.
  
  On a reported basis, Blue Nile’s total orders were down 7 percent, and its average ticket rose by 9.7 percent to $1,787. However, both of these figures include unusual factors (cited above) in last year’s results. On an “apples-to-apples” basis, orders this year were up 13 percent (excluding the low-ticket Google promotion results), but the average ticket was down 5.5 percent (excluding both the Google promotion results and the $1.5 million single ticket last year).
  
  Overall, traffic to Blue Nile’s website was up, and its conversion rate (browsers-to-buyers) was also up, according to management.
  
  Sales by price range were as follows in the quarter:
• $100,000 and higher average ticket = weak
• $50,000 to $100,000 average ticket = up
• $5,000 to $50,000 average ticket = down, since sales in this price range are more reliant on credit
• $5,000 and below = up

Blue Nile’s management noted that its customers were “shopping down” – buying lower-ticket, smaller diamonds.

 

We believe that the company’s sales mix remains about 70 percent engagement diamonds, 20 percent non-engagement diamonds, and 10 percent other fashion jewelry.

The company noted that it began collecting sales tax on orders from New York due to new legislation, but it had seen no impact on demand from its customers in that region.

 

• International sales were up nearly 180 percent - Sales into the 25 international markets that Blue Nile serves were $8.1 million in the quarter, up 179 percent from last year’s $2.9 million. Except for its Canadian customers, shoppers in overseas markets are buying on either the U.S. website or the U.K. website, and paying in U.S. dollars or U.K. pounds sterling.

• Merchandise trends are changing – Blue Nile plans to focus more on fashion jewelry for two reasons: 1) that is a category which is selling in today’s market; and, 2) this is a category that its engagement ring customers are seeking, after they are married. The company plans to launch a new Fall collection. Blue Nile’s customers appear to remain loyal to the company, long after they have purchased their engagement ring online.

• Blue Nile’s “real” gross margin rose marginally in the quarter – Blue Nile reported a gross margin of 20.5 percent, down slightly from last year’s reported 20.7 percent. However, last year’s margin included a credit for shipping costs that added 30 basis points to the “reported” margin. On an apples-to-apples basis, this year’s gross margin of 20.5 percent was slightly higher than last year’s adjusted 20.4 percent. The modest increase this year was due to two factors: 1) a sales mix shift toward smaller diamonds which carry an inherently higher margin; and, 2) selective price increases.

• The operating expense ratio rose – On a reported basis, Blue Nile’s operating expenses were 14.6 percent of sales, up from last year’s 13.7 percent. However, stock-based compensation distorted those numbers. When stock-based compensation in removed, the company’s operating cost ratio was 12.1 percent versus 11.8 percent last year. Thus, the year-to-year gap was much smaller in reality.

• Balance sheet ratios remain solid – Blue Nile has virtually no debt on its balance sheet, and its vendor float continues to rise. Management said that its suppliers were eager to do business with the company since it was paying for merchandise it orders, rather than asking for further credit extensions or more memo goods.
  
  The company’s inventory turn declined modestly to 14.0x/year from last year’s 15.6x/year. These numbers are so far above the industry average of 1.0x that this slight decline is not meaningful.

• Sales expectations reduced – Earlier this year, Blue Nile has been forecasting that sales would rise by about 10 percent in 2008 versus 2007. It revised its prediction based on second quarter sales trends: it now is suggesting that sales will be up in the mid-single digit range – more or less +5 percent. However, this fiscal year will be 53 weeks, compared to 52 weeks last year. The company would not disclose the expected sales impact of the 53^rd week. Since the extra week occurs at the end of December, it could easily represent 2-3 percent of total annual sales.
  
  While Blue Nile said it expects earnings per share to be roughly flat this year, it is important to note that this means reported total net profit will be down. Because the company has an ongoing stock buyback program in place, it will have fewer shares outstanding at year-end.