Virtual CEO: Blue Nile

Blue Nile, an online retailer of jewelry, has an interesting set of challenges to face in the future.

During a recent call with analysts to discuss third quarter results, management made several interesting observations.

• Ad spend as a percentage of revenue is four percent, and has held constant in spite of increases in the cost of online marketing.
• With brands moving online to advertise, management has decided to not compete by spending more on online advertising. Management states they lowered prices instead. The reduction in prices resulted in twenty-four percent increase in year-to-date net sales. However, gross profit only increased by eleven percent, due to price reductions. Gross profit is about twenty percent of net sales.
• Management is focusing on increasing conversion on the website, believing this is a key driver of future profitability. Management states that conversion rates are improving, compared with last year.
• Repeat purchasing skews toward non-engagement merchandise (which has better gross margins than engagement merchandise).

Time for you to play Virtual CEO. If online marketing costs are going to continue to increase, what would you do to grow your business?

• Follow the updraft in online marketing costs by spending more for the same amount of traffic.
• Lower prices, and accept the risk of a less-affluent audience. In other words, are you willing to trade your target audience for one that is less affluent, as a way of combating increased online marketing expenses?
• Do you have a different strategy you would employ?

Online pureplay retailers face the potential for long-term profitability decreases as the cost of online marketing increases. How would you strategically attack this problem? What marketing tactics would you employ to drive repeat business (which yields a higher gross profit)?

Blue Nile, Chicos, PetSmart and NASCAR

A few tidbits from recent investor conference calls, courtesy of 123Jump.

At Blue Nile, management states that it measures market productivity by summing sales in a market (San Francisco), and dividing sales by the number of people living in the market. In markets like San Francisco, they claim to generate $2.00 sales per person. In rural markets, they claim to drive maybe $0.30 per person.

At Chicos, management discussed a change in advertising strategy, yet another one that benefits compiled databases, and spells doom for television and magazines. A quote, "the company was not able to quantify any real positive effect from television advertising". Management also states that coupons are the number one driver of sales for the company.

At PetSmart, the business generated 5.5% EBIT on sales of just over $3 billion dollars, through nine months. Management stated that they spend 2.4% of sales on marketing. That sounds small until you realize that, though nine months, the total is over $60 million dollars.

Ever wonder if NASCAR is a cash cow? International Motorsports, which owns many of the tracks NASCAR races at, earned $182.4 million in operating income on net sales of $544.9 million, through nine fiscal months. My goodness. How do I get a job there? That's simply stunning.

Business Review: PC Connection

PC Connection significantly improved the profitability of its business during the past year. Let's take a look at some of the key findings from their most recent 10-Q statement.

Through nine months, net sales increased by fifteen percent to just over $1.2 billion dollars. Earnings before taxes dramatically improved, from $7.8 million last year to $14.7 million this year.

• Small Businesses and Consumers = $655.6 million dollars sales and $4.3 million dollars profit. Sales improved seven percent, profit improved by $1.4 million dollars. Gross Margin was 13.5% in 2006 verses 12.5% in 2005.
  
• Large Accounts = $350.0 million dollars sales and $17.6 million dollars profit. Sales improved by a whopping forty-nine percent, profit improved by $5.2 million dollars. Gross Margin was 10.9% in 2006 verses 10.3% in 2005.
  
• Public Sector = $197.8 million dollars sales and a loss of $7.2 million dollars. Sales were essentially flat, while profit improved by $0.3 million dollars. Gross Margin was 12.3% in 2006 verses 11.5% in 2006.
  

By product offering, sales improved nicely across all merchandise divisions.

• Notebooks and PDAs = +7% (the largest merchandise division, $210,000,000 YTD).
  
• Desktops and Servers = +12%
• Storage Devices = +14%
• Software = +20%
• Net/Com Products = +19%
• Printers and Supplies = +11%
• Video, Imaging & Sound = +25%
• Memory & System Enhancements = +8%
• Accessories & Other = +23%

Management makes several interesting observations in this report.

• Small business sales increased among businesses, but decreased among consumers.
• Increases in online sales were offset by decreases in telephone sales.
• The number of catalogs mailed were decreased verses 2006, focusing instead on more diverse strategies to drive sales among businesses.
  
• Large accounts benefited from inclusion of sales from Amherst sales representatives, and a twelve percent growth in organic sales.
• Gross margins were improved by vendor considerations.

I enjoy reading about businesses that I am not familiar with. Specifically, I have generally worked for businesses with gross margins in the forty to sixty percent range, businesses that largely developed their own products.

In this case, PC Connection largely sources merchandise from vendors who can and do sell their own merchandise through their own distribution channels, or through other channels. For instance, HP computers can be sold via HP's website, or through businesses like Best Buy. Competitively, PC Connection would have to differentiate itself in some manner, so that customers choose their business. In my case, I buy from PC Connection because merchandise is shipped in a rapid and inexpensive manner.

As you can see, PC Connection faces challenges managing a business with gross margins in the twelve percent range. Downturns in business can cause the business to not leverage fixed expenses. Large accounts appear highly profitable, as sales and margin leverage a minimal expense structure. The majority of the profit generated by PC Connection is generated by only 87 employees. More than four hundred employees manage the small business segment.

It will be interesting to see if PC Connection can continue to drive sales and profit increases at a time when margin pressure increases in the computing industry. What do you think about the prospects for PC Connection?