Blue Nile: On the Rocks

Suffering from a pullback in consumer spending, the online jewelry retailer projects no growth in profits for 2008

With recession worries still looming, a noticeable slowdown in consumer spending has high-end retailers like Blue Nile (NILE) making very conservative predictions for financial results this year, much to investors' chagrin.

After the market close on Feb. 12, the online diamond and fine jewelry retailer reported fourth-quarter earnings that met Wall Street's expectations. But the company expressed a much weaker outlook for 2008 sales and earnings than the market had counted on.

The Seattle-based company reported a 23.3% gain in sales to $111.9 million in the fourth quarter, vs. $90.7 million in the year-ago period. Earnings per share jumped 28.6% from a year ago to 45 cents, from 35 cents, thanks to 15% higher total orders and a 7% gain in the average order size compared with the fourth quarter of 2006. The results beat the consensus estimate among Wall Street analysts by one penny.

For all of 2007, Blue Nile's EPS rose 36.8% to $1.04, from 76 cents a year ago, on a nearly 27% hike in revenue to $319.3 million.

Despite its strong competitive position, Blue Nile said in the earnings release that it's being very cautious about expectations for 2008, as the slowdown in consumer spending has created "tremendous uncertainty in the luxury retail sector."

For the first quarter of 2008, the company sees no sales growth from the year-ago period and a profit of 11 cents to 14 cents per share, including an estimated seven-cents stock compensation expense. Even without the stock compensation hit, the forecast falls short of the average estimate of 23 cents per share among Wall Street analysts.

Blue Nile is targeting at least 10% growth in net sales for the year and earnings that are roughly flat with those in 2007. The company also announced that Diane Irvine had been appointed chief executive, succeeding Mark Vadon, who has assumed the newly created position of executive chairman.

Investors did not like what they heard, and sent Blue Nile shares down 17% to 44.67, after bouncing back from a low of 40.02 earlier on Feb. 13.

On a conference call to discuss the latest results, the company noted better than expected growth in its international business and said the European and Asian markets could generate more than $100 billion in sales over time. Blue Nile also said it's continuing to expand its market share with a shift to online purchasing and ongoing brand strength, which has been driven by repeat and referral business. The company repurchased $6.5 million in stock in the last three months of 2007 and increased authorization to $150 million for future buybacks.

Oppenheimer & Co., in a research note on Feb. 13, gave a nod to the positive developments but cited a drop in domestic growth to 19% in the fourth quarter, the lowest in almost two years. Analyst Malindi Davies said the 2008 outlook is "well below our expectations and the company's stated goal of long-term 20%-30% top line growth and 25% bottom line" growth. (Oppenheimer & Co. makes a market in Blue Nile’s securities.)

The market is hoping the $170 billion economic stimulus package that President Bush signed into law on Feb. 13 will give U.S. consumers a much-needed shot in the arm by putting at least $600 into the pockets of everyone who paid taxes last year. But that may not benefit high-end retailers as much as those that offer more affordable merchandise.

Tim Boyd, an analyst who covers online retailers at American Technology Research in Greenwich, Conn., said he's been hearing some anecdotal evidence that even well-heeled consumers may be strapped for cash these days.

Dealers in New York City's midtown diamond district have told him they've been seeing high-end clients come in and try to pawn off expensive jewelry for very low prices lately.

"[These clients] were so overextended on their credit cards and worried about making their mortgage payments," Boyd said he was told. "It got us thinking this [consumer slowdown] is going to be worse than we thought."

Boyd, who has had a sell rating on Blue Nile shares for a while, said the company's comments about a big decline in its average selling price was telling and likened it to what befell other luxury retailers such as Tiffany & Co. (TIF), Zale (ZLC) and Gucci during the 2001 economic slump. Back then, luxury retailers suffered from erosion in their average selling prices because demand dried up for products at higher price levels, he explained.

"It's not that guys have stopped buying engagement rings or are going to stop buying them," he said. "But instead of spending $15,000 like they were a year ago, they're only spending $8,000 or $9,000, which is a huge hit."

One reason Blue Nile was able to widen its margins in the fourth quarter was that it was selling more lower-priced jewelry, which have higher margins than higher-priced items, Boyd said.

But looking ahead, Boyd said the company’s margins could be pressured given soaring prices for platinum and other precious metals. Though these metals account for only 10% of Blue Nile’s input costs, margins could suffer if the company chooses not to raise prices.

Lastly, because 2007 was a stellar year for Blue Nile, the company could become a victim of its own success, with comparable sales likely to be "unbelievably hard" this year, he said.

Boyd has a price target for the shares of 33. "The stock is so heavily shorted right now that it may take some time to work its way down there, but it's only a matter of time," he said.

Citi Investment Research downgraded the stock to hold from buy on Feb. 12, saying that its upgrade in December to buy was a mistake. Analyst Mark Mahaney cited a significantly reduced growth outlook, a lack of near-term catalysts and tough comparisons with the first half of 2007. But he said the shares deserve to be rated hold rather than sell due to clear market share gains, long-term international growth prospects, a 6% free cash flow yield with buyback potential in 2008, unique relationships with suppliers and a strong track record for business execution.

Mahaney also cut his price target to 50 from 74. "We did not believe the jewelry market would weaken so dramatically and we did not believe Blue Nile would be this cyclical," he said in a research note. (Citigroup makes a market in Blue Nile’s publicly traded securities.)

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