Is Blue Nile STILL an Internet Growth Company?

Implications: Blue Nile continues to be priced as if it were a Internet growth company.  Here's why that may be a mistake.

Analysis: Shares of Blue Nile, the on line diamond retailer, have traded higher since the company reported sales had grown 3.8% in the first quarter of 2008.  That’s a substantial decline from the 34% growth Blue Nile experienced in the first quarter of 2007.  In fact, domestic US sales which comprise about 92% of Blue Nile’s business were down approximately 1%.  All of its sales growth came from international business, especially in Canada, UK, and Western Europe.   

For much of last year Blue Nile was priced as an Internet growth stock.  Like the heady days before the Internet bubble burst in the late 1990’s, the company was selling for as much as 100X earnings.  Now, its valuation has declined to about 49X earnings, but that’s still high by bricks and mortar retailing measures.  For instance, Tiffany recently traded for a P/E of 20.55, while Birks and Mayors, a luxury retailer with sales about the same magnitude as Blue Nile, traded at a P/E of 7.55.  The question for investors is:  Are Blue Nile’s growth days over? 

That’s hard a hard question, but realistically, the answer is probably yes, at least in terms of Internet growth metrics.  There are several reasons why.  

First, it’s doubtful if Blue Nile ever had the capacity to grow like Amazon.com or ebay.com.  While, Blue Nile had proffered the goal of achieving $700 million in sales with in 5 years, it was problematic whether the company could continue to grow its large diamond business, while simultaneously broadening assortments and targeting the female personal purchase jewelry customer. 

With more than one-third of Internet jewelry market, Blue Nile’s sales are already twice that of its nearest competitor, Tiffany.  Accordingly, market share growth will likely be harder and more expensive to achieve.  That's especially true since Internet sales growth has also  slowed.  So, you have to ask whether Blue Nile could achieve  40% or 50% share of the Internet jewelry sales and the answer is probably no.  

Second, the company's free ride is over.  Earlier, Blue Nile was able to steal market share from a large number of fragmented jewelry stores.  According to the Commerce Department, there are more than 23,000 retailers selling jewelry in the US, many of which selling carat and larger diamonds.  Since luxury sales had been growing at near double digit rates, the majority of the Blue Nile's competition continued to grow in spite of the Internet retailers success.

Now, Blue Nile is seen as a competitive threat, not only to the industry at large, but to formidable competitors like Tiffany.  With the economy slowing, competitors can no longer ignore Blue Nile.  Tiffany has already begun to invest in its e-commerce business and DeBeers has started marketing fine diamond jewelry over the Internet.  Meanwhile, smaller guild jewelers have lowered their margins on large loose diamonds.  The fact is, much of what Blue Nile does, can be replicated in most local jewelry stores; with the added advantage of face to face interaction with a knowledgeable jeweler.  That fact alone is a formidable threat to Blue Nile. 

Third, accepting that US growth may be harder to achieve for now, Blue Nile has focused on growing its international business.  According to the company, foreign sales grew about 124% to about $5.7 million in the first quarter.  That’s equivalent to about a $3.2 million increase which annualizes to about a $15 million for 2008. Some may consider that good growth in a depressed economy.  However, given the company’s small international sales base, weak dollar, and stronger international economy, it begs the question of how relevant Blue Nile’s Internet format is to large diamond customers overseas.  

In addition, there’s every likelihood Western Europe’s economy will weaken in the second quarter. Driven in part by a weak dollar which will reduce US tourism this summer and by high interest rates, it isn’t clear Blue Nile’s sales growth overseas will strengthen.  Management says its initial tests in Asia have been favorable, but it’s doubtful the company has either the distribution or payment infrastructure to capitalize on the markets emerging in China, India, or the Middle East.    

Fourth, consumer buying behavior is changing.  That’s both good and bad news for Blue Nile.  The good news is that more customers may chose to shop the Internet to reduce gasoline consumption.  On the other hand, it’s problematic when and to what magnitude aspirational large diamond sales will reemerge in the US domestic market.  DeBeers has already recognized the shift in demand.  Beginning in 2008, it has reallocated a portion of its advertising spend from North America to emerging nations such as China, India, and the Middle East.   

Fifth, credit will remain limited in the US which will retard aspirational diamond sales.  Notwithstanding, interest rates are low, additional liquidity is not flowing from the financial markets to the consumer.  Moreover, analysts project that consumers will have significantly less liquidity in 2008 and 2009 as home owners refinance homes and borrow less additional cash in the process.  That decrease in consumer liquidity has been estimated to be in excess of $100 billion when compared to 2007 figures.  Granted, couples will still buy engagement rings and fine jewelry for gifts, but units will continue to decline.  

Sixth, Blue Nile’s approach to the business is more conservative. That’s evident in their decision not to match off to the 2007 Google promotion.  In a declining economy, a low cost format like Blue Nile could have chosen to buy market share as higher priced competitors cut back.  But it didn’t and that says a lot about how the company views its future growth prospects.   

Last, Blue Nile now says 2008 sales will grow about 10%.  But, other than wishful thinking, just how they expect to do it is uncertain.  Historically, the first quarter accounts for about 21.5% of their business.  Assuming second quarter sales trend at about the same growth rate, Blue Nile will have to increase sales by about 15% in the second half of the year. That seems highly unlikely given both the company’s current trends, marketing challenges, and current business philosophy.