The Motley Fool's David Gardner recently spoke with Mark Vadon, co-founder and CEO of Blue Nile
David Gardner: Mark, welcome. I want to start with the following. Blue Nile recently announced that growth will be slower than expected. What is behind the slowdown?
Mark Vadon: Yeah, we have seen pretty sharp increases in the cost of online advertising, and it is making it harder in this environment to acquire customers, so we are very committed to being a profitable business and continuing to maximize the operating profit and free cash flow of the business. So in this environment, we are being a little bit more conservative with how we acquire customers, and that is translating to slightly slower growth over the next few quarters.
DG: I guess it is the story about paid search, the method of online advertising where companies are bidding for the right to be associated with particular keywords -- the word "diamond," for example. For its top five keywords, Blue Nile's paid search costs rose by more than 80%. You said that competition for particular keywords has become, well, irrational. Explain.
MV: Yeah, we are seeing the cost of all online advertising going up, but I think with search we have seen, by far, the largest increases. I think people are very excited about Google
During Q4 of 2005, we saw very rapid increases. We are the largest [presence] on the Internet in the jewelry space, and we feel if there is a qualified customer, we can monetize them better than anybody else in the world. So when we are seeing prices being paid to acquire customers that are high for us, we are pretty certain other people are losing money in order to buy those customers.
DG: It's time for our annual rank-the-competition question. This year, we would like you to rank the following companies in terms of what competitive threat they represent to your future cash flow. They are Tiffany
MV: Gosh, they are all great companies. You know, when we look at who we think is the most significant, competitively, of that set, it would be by far Tiffany. Tiffany just has so much credibility in the jewelry space; it has amazing products. When we look at what we are trying to build 20 years from now, we would want to be seen as having the credibility and the brand that Tiffany has built over time. Tiffany has been in business for a very, very long time. It has built a fantastic brand, and it has taken care of its customers. I think it is just a great competitor.
eBay has been a competitor of ours since the first day we were in business. They sell a lot of jewelry, but there is not much overlap. They are selling lower price points and not so much engagement [rings]. I think it is similar for Amazon. I think people are comfortable buying lower price point items from Amazon, but it is hard to say "Will you marry me?" from Amazon.com.
Zale's has a very different product line. So I think as you go through all of those, by far the most significant competition would be Tiffany.
DG: Is a Tiffany diamond qualitatively different from a Blue Nile diamond? Or are they all just coming from the same place?
MV: You know, Tiffany has incredible products, but I would have to say I think the quality of the jewelry coming out of Blue Nile is fantastic and is definitely up there with anybody else in the marketplace.
The good news is, if you are buying jewelry from Blue Nile, you are paying 20% to 40% less than you would pay in a traditional store. We just run on a very different margin structure. Tiffany's gross margins are in the high 50s, so for every dollar of jewelry they buy, they are selling it for roughly close to $2.50. Our margins are in the low 20s, so when we buy a dollar's worth of jewelry, we are only charging you roughly $1.25 for it. So there is just so much more value on the table there for consumers. The goal for us is to make sure the quality of the product is up there with Tiffany or anybody else.
DG: What portion of Tiffany's markup do you think comes down to bricks and mortar? And what portion of Tiffany's markup comes down to just "Hey, we are Tiffany"?
MV: You know, I think, definitely, if you are buying a product from Tiffany and it is coming in the blue box, you always know it is going to be well received. There is a premium associated with that, and Tiffany definitely charges that premium and makes some great margins. Consumers have been willing to pay it over the years, and that is great for Tiffany.
DG: And of course back in 1999, the explosion in advertising was really venture capital-backed. It was me starting my business, getting venture capital [VC], and then overspending it in inefficient ways. Where is the money coming from today? Are you saying it is the same VC money? Or are these coming from more mature organizations that are just trying to keep up?
MV: We are seeing two types of players really bidding aggressively on paid search. One is smaller companies that are really small jewelry stores out there who are getting aggressive for very short periods of time, so they will come online on Google for a matter of days or weeks and spend a relatively high amount of money until they run out. We are also seeing very large companies who traditionally have not played with the Internet, dabbling in it. We think they are trying to understand the economics of it. I think we are seeing a combination of different types of players spending money, but what they tend to have in common is not as much experience with the online environment.
DG: Let's talk some inside baseball regarding stock options. Blue Nile has been generous in the awarding of stock options and that is an added expense for your business. Any plans to lighten up on stock option compensation in the next year or two?
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Fool co-founder David Gardner owns shares of Blue Nile, Amazon.com, and eBay. Amazon.com and eBay are Motley Fool Stock Advisor recommendations. Blue Nile is also a Motley Fool Hidden Gems pick. The Fool has adisclosure policy.