Case stuDy Blue Nile and Diamond Retailing1

Case stuDy Blue Nile and Diamond Retailing1

A customer walks into your jewelry store with printouts of diamond selections from Blue Nile, a company that is the largest online retailer of diamonds. The list price for the customer’s desired diamond is only $100 above your total cost for a stone of the same characteristics. Do you let the customer walk, or come down in price to compete?2

This dilemma has faced many jewelers. Some argue that jewelers should lower prices on stones to keep the customer. Future sales and add-on sales such as cus- tom designs, mountings, and repairs can then be used to make additional margins. Others argue that cutting prices to compete sends a negative signal to loyal cus- tomers from the past who may be upset by the fact that they were not given the best price.

As the economy tightened during the holiday sea- son of 2007, the differences in performance between Blue Nile and bricks-and-mortar retailers were startling. In January 2008, Blue Nile reported a 24 percent jump in sales during its fourth quarter. For the same quarter, Tif- fany posted a 2 percent drop in domestic same-store sales, and Zales reported a 9 percent drop. The chief operating officer of Blue Nile, Diane Irvine, stated, “This business is all about taking market share. We look at this type of environment as one of opportunity.”

The Diamond Retailing Industry

For both wholesalers and retailers in the diamond indus- try, 2008 was a very difficult year. It was so bad at the supply end that the dealers’ trade association, the World Federation of Diamond Bourses, issued an appeal for the diamond producers to reduce the supply of new gems entering the market in an effort to reduce supply.

However, the world’s largest producer, De Beers, appeared unmoved, refusing to give any commitment to curtail production. The company had recently opened the Voorspoed mine in South Africa, which, when fully operational, could add 800,000 carats a year into an

already oversupplied market. Historically, De Beers had exerted tremendous control over the supply of diamonds, going so far as to purchase large quantities of rough dia- monds from other producers. In 2005, the European Commission forced De Beers to phase out its agreement to buy diamonds from ALROSA, the world’s second largest diamond producer, which accounted for most of the diamond production in Russia. Russia was the sec- ond largest producer of diamonds in the world after Botswana.

Although discount retailers such as Walmart and Costco continued to thrive, the situation was difficult for traditional jewelry retailers. Friedman’s filed for Chapter 11 bankruptcy protection in January 2008, followed by Chicago-based Whitehall in June. When it filed for bankruptcy, Friedman was the third largest jewelry chain in North America, with 455 stores, whereas Whitehall ranked fifth, with 375 stores in April 2008. In February 2008, Zales announced a plan to close more than 100 stores that year. This shakeup offered an opportunity for other players to move in and try to gain market share.

With the weakening economy, the third and fourth quarters of 2008 were particularly hard on diamond retailers. Even historically successful players such as Blue Nile, Tiffany, and Zales saw a decline in sales and a significant drop in their share price. As customers tight- ened their belts and cut back on discretionary spending, high-cost purchases such as diamond jewelry were often the first to be postponed. The situation worsened as competition for the shrinking number of customers became fiercer. In such a difficult environment, it was hard to judge which factors could best help different jewelry retailers succeed.

Blue Nile

In December 1998, Mark Vadon, a young consultant, was shopping for an engagement ring and stumbled

1This case was written jointly with Professor Roby Thomas of Elmhurst College. 2Stacey King, “The Internet: Retailers’ New Challenge,” Professional Jeweller Magazine, August 1999.

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across a company called Internet Diamonds, run by Seattle jeweler Doug Williams. Vadon not only bought a ring but also went into business with Williams in early 1999. The company changed its name to Blue Nile by the end of 1999 because the new name “sounded elegant and upscale,” according to Vadon.

On its website, Blue Nile articulated its philoso- phy as follows: “Offer high-quality diamonds and fine jewelry at outstanding prices. When you visit our web- site, you’ll find extraordinary jewelry, useful guidance, and easy-to-understand jewelry education that’s perfect for your occasion.”

Many customers (especially men) liked the low- pressure selling tactics that focused on education. Besides explaining the four Cs—cut, color, clarity, and carat—Blue Nile allowed customers to “build your own ring.” Starting with the cut they preferred, customers could determine ranges along each of the four Cs and price. Blue Nile then displayed all stones in inventory that fit the customer’s desired profile. Customers selected the stone of their choice, followed by the setting they liked best. Blue Nile also allowed customers to have their questions resolved on the phone by sales reps who did not work on commission. This low-pressure selling approach had great appeal to a segment of the population. In a BusinessWeek article in 2008, Internet entrepreneur Jason Calacanis was quoted as saying that shopping for his engagement ring (for which he spent “tens of thousands of dollars”) on Blue Nile “was the best shopping experience he never had.”3

The company focused on providing good value to its customers. Whereas retail jewelers routinely marked up diamonds by up to 50 percent, Blue Nile kept a lower markup of around 20 percent. Blue Nile believed that it could afford the lower markup because of lower inven- tory and warehousing expense. Unlike jewelry retailers who maintained stores in high-priced areas, Blue Nile had a single warehouse in the United States in which it stocked its entire inventory.

The company strategy was not without hurdles because some customers did not care as much about underpricing the competition. For example, some cus- tomers preferred “a piece of fine jewelry in a robin’s egg blue box with Tiffany on it”4 to getting a price discount. Also, it was not entirely clear that customers would be

willing to spend thousands of dollars on an item they had not seen or touched. To counter this issue, Blue Nile offered a 30-day money back guarantee on items in orig- inal condition.

In 2007, the company launched websites in Canada and the United Kingdom and opened an office in Dublin with local customer service and fulfillment operations. The Dublin office offered free shipping to several countries in Western Europe. The U.S. facility handled international shipping to some countries in the Asia–Pacific region. International sales had increased from $17 million in 2007 to more than $62 million in 2012.

By 2007, Blue Nile had sold more than 70,000 rings larger than a carat, with 25 orders totaling more than $100,000. In June 2007, the company sold a single diamond for $1.5 million. Forbes called it perhaps “the largest consumer purchase in Web history—and also the most unlikely.”5 The stone, larger than 10 carats, had a diameter roughly the size of a penny. Blue Nile did not have the stone in inventory, but its network of suppliers quickly located one on a plane en route from a dealer in New York to a retailer in Italy. The stone was rerouted to Blue Nile headquarters in Seattle and transported in a Brinks armored carrier to the buyer—and the whole pro- cess took only three days.

In February 2014, Blue Nile offered more than 140,000 diamonds on its site. Of these diamonds, more than 50,000 were one carat or larger, with prices up to $2.9 million. Almost 76,000 diamonds on the Blue Nile website were priced higher than $2,500. In 2010, com- pany CEO Diane Irvine said, “We’re not positioned as a discounter. We are selling a very high-end product but selling it for much less.” The 2012 annual report stated that “we aim to limit our diamond offerings to those pos- sessing characteristics associated with high quality.”

In 2012, the company had sales of about $400 mil- lion with a net income of $8.4 million. Although sales had risen, income had dropped relative to 2011. The company had also started to offer a broad range of non- engagement products, including rings, wedding bands, necklaces, pendants, bracelets, and gifts and accessories containing precious metals, diamonds, gemstones, or pearls. The company, however, maintained that the engagement category was its core business.

3Jay Greene, “Blue Nile: No Diamond in the Rough,” BusinessWeek e.biz, May 2000. 4King, “The Internet: Retailers’ New Challenge.” 5Victoria Murphy Barret, “The Digital Diamond District,” Forbes.com, October 2007.

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Zales

The first Zales Jewelers was established by Morris (M. B.) Zale, William Zale, and Ben Lipshy in 1924. Their marketing strategy was to offer a credit plan of “a penny down and a dollar a week.” Their success allowed them to grow to twelve stores in Oklahoma and Texas by 1941. Over the next four decades, the company grew to hundreds of stores by buying up other stores and smaller chains.

In 1986, the company was purchased in a lever- aged buyout by Peoples Jewelers of Canada and Swarovski International. In 1992, its debt pushed Zales into Chapter 11 bankruptcy for a year. It became a public company again in that decade and operated nearly 2,400 stores by 2005. The company’s divisions included Pierc- ing Pagoda, which ran mall-based kiosks selling jewelry to teenagers; Zales Jewelers, which sold diamond jew- elry for working-class mall shoppers; and the upscale Gordon’s. Bailey Banks & Biddle Fine Jewelers, which offered even pricier products out of fancier malls, was sold by Zale Corporation in November 2007.

Three years of declining market share, lost mostly to discounters such as Walmart and Costco, put pressure on Zales to decide on a makeover by 2005. Zales dumped its lower-value 10-karat gold jewelry and modest-quality diamonds. The goal was to make the jeweler more upscale and fashion conscious, moving away from its promotion-driven, lower-end reputation. Unfortunately, the move was a disaster. There were delays in bringing in new merchandise, and same-store sales dropped. The company lost many of its traditional customers without winning the new ones it desired. It was soon passed by Akron, Ohio-based Sterling (a subsidiary of the Signet Group) as the largest jeweler in the United States. The chief executive officer of Zale Corporation was forced to resign by early 2006.

In August 2006, under a new CEO, Zales started a transition to return to its role as a promotional retailer focused on diamond fashion jewelry and diamond rings. The transition involved selling nearly $50 million in dis- continued inventory from its upscale strategy and an expenditure of $120 million on new inventory. As a result of the inventory write-downs, Zales lost $26.4 million in its quarter ending July 31, 2006.

The company had some success with its new strat- egy but was hurt by the rise in fuel prices and falling home prices in 2007 that made its middle-class custom- ers feel less secure. Its core customers hesitated to buy jewelry as they battled higher prices for food and fuel.

Zales reported a profit of $1.5 million in the quarter end- ing July 31, 2007, but same-store sales fell by 0.5 per- cent. In February 2008, the company announced a plan to close approximately 105 stores, reduce inventory by $100 million, and reduce staff in company headquarters by about 20 percent. The goal of this plan was to enhance the company’s profitability and improve its overall effec- tiveness. After many years of losses, the company finally reported a profit for 2012 (see Table 4-14).

Tiffany

Tiffany opened in 1837 as a stationery and fancy goods emporium in New York City. It published its first catalog in 1845. The company enjoyed tremendous success, with its silver designs in particular becoming popular all over the world. In 1886, Tiffany introduced its now famous “Tiffany setting” for solitaire engagement rings. The Tiffany brand was so strong that it helped set dia- mond and platinum purity standards used all over the world. In 1950, Truman Capote published his best seller Breakfast at Tiffany’s, which was released as a success- ful film in 1961. After more than a century of tremen- dous success with its jewelry and other products, the company went public in 1987.

Tiffany’s high-end products included diamond rings, wedding bands, gemstone jewelry, and gemstone bands with diamonds as the primary gemstone. The com- pany also sold non-gemstone gold, platinum, and ster- ling silver jewelry. Other products included watches and high-end items for the home, such as crystal and sterling silver serving trays. Besides its own designs, Tiffany also sold jewelry designed by Elsa Peretti, Paloma Picasso, the late Jean Schlumberger, and architect Frank Gehry.

By 2012, Tiffany had 275 stores and boutiques all over the world, with about 90 of them in the United States. Of its global outlets, Tiffany had more than 50 in Japan and more than 65 in the rest of the Asia-Pacific region. Stores ranged from 1,300 to 18,000 square feet, with an average of 7,100 square feet. Its flagship store in New York contributed about 10 percent of the company’s sales in 2007. Besides retail outlets, Tiffany also sold products through a website and catalogs. The company, however, did not offer any engagement jewelry through its website as of 2012. Its high-end products, including jewelry, were sold primarily through the retail stores. The direct channel focused on what Tiffany referred to as “D” items, which consisted primarily of non- gemstone sterling silver jewelry with an average price of $200 in 2007. Category D sales represented about 58 percent of

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total sales for the direct channel. In contrast, more than half the retail sales came from high-end products such as diamond rings and gemstone jewelry with an average sale price in 2007 higher than $3,000.

Tiffany maintained its own manufacturing facili- ties in Rhode Island and New York but also continued to source from third parties. In 2007, the company sourced almost 60 percent of its jewelry from internal manufac- turing facilities. Tiffany had a retail service center in New Jersey that focused on receiving product from all over the world and replenishing its retail stores. The company had a separate customer fulfillment center for processing direct-to-customer orders.

Until 2003, the company did not purchase any rough diamonds, focusing entirely on the purchase of polished stones. Since then, the company established diamond-processing operations in Canada, South Africa, Botswana, Namibia, Belgium, China, and Viet- nam. In 2007, approximately 40 percent of the dia- monds used by Tiffany were produced from rough diamonds purchased by the company. Not all rough diamonds could be cut and polished to the quality

standards of Tiffany. Diamonds that failed to meet Tif- fany’s standards were then sold to third parties at mar- ket price, sometimes at a loss.

In 2012, 90 percent of Tiffany’s net sales came from jewelry, with approximately 48 percent of net sales coming from products containing diamonds of various sizes.6 Products containing one or more diamonds of one carat or larger accounted for more than 10 percent of net sales in 2007. Select financial details of Tiffany’s perfor- mance in 2012 are shown in Table 4-14.

The Tiffany brand’s association with quality, lux- ury, and exclusivity was an important part of its success. No other diamond and jewelry retailer enjoyed margins anywhere near those enjoyed by Tiffany. In its annual reports, the company listed the strong brand as a major risk factor because any dilution in its brand image would have a significant negative impact on its margins.

Study Questions

1. What are some key success factors in diamond retailing? How do Blue Nile, Zales, and Tiffany compare on those dimensions?

Table 4-14 Select Financial Data for Blue Nile, Inc., Zale Corporation, and Tiffany & Co. (in millions of dollars) for 2012

Blue Nile Zale Tiffany

Net sales 400.0 1,888.0 3,794.2

Cost of sales 325.0 903.6 1,631.0

Gross profit 75.1 984.4 2,163.2

Selling, general, and administrative expenses

62.8 915.5 1,466.1

Operating income 12.3 35.1 697.2

Net income 8.4 10.0 416.1

Cash and cash equivalents 87.0 17.1 504.8

Net receivables 4.4 – 253.5

Inventories 33.3 767.5 2,234.3

Total current assets 125.9 837.2 3,151.6

Property and equipment 7.9 108.9 818.8

Other assets 89 35.7 354.0

Total assets 145.9 1,187.3 4,630.9

Accounts payable 128.6 327.6 325.9

Stockholder equity 14.1 183.3 2,598.7

6Tiffany Annual Report, March 2013.

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2. What do you think of the fact that Blue Nile carries many stones priced at $2,500 or higher, whereas a large fraction of the products sold from the Tiffany website are priced at around $200? Which of the two product categories is bet- ter suited to the strengths of the online channel?

3. What do you think of Tiffany’s decision to not sell engage- ment rings online? What do you think of Blue Nile’s growth into the non-engagement category?

4. Given that Tiffany stores have thrived with their focus on selling high-end jewelry, what do you think caused the failure of Zales’ upscale strategy in 2006? What products should Zale focus on?

5. Which of the three companies do you think is best struc- tured to deal with weak economic times?

6. What advice would you give to each of the three compa- nies regarding its strategy and structure?

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