Why This Company Is the Best Play on the Affordable Luxury Theme

Source: Blue Nile

Following the 2008-2009 Global Financial Crisis, household incomes have been on the decline and a culture of frugality has set in. This has led to the rise of companies that capitalize on the 'Affordable Luxury' theme, offering luxury goods at affordable prices.

One such beneficiary is Blue Nile , an online retailer of high-quality diamonds and fine jewelry which started up in 1999. It grew its top line faster than its peer Tiffany for the past one-year, three-year, and five-year periods. In its most recent financial year, Blue Nile increased its revenue by 12.5%, which compares to more modest sales growth of 6.2% for Tiffany. What's the magic behind Blue Nile's success?

The value proposition
Blue Nile's gross margin of 19% is about one-third that of Tiffany. On the surface, it might seem that Blue Nile has significantly lower pricing power than Tiffany and its products are less appealing. This isn't true. In fact, Blue Nile's lower gross margin reflects the value proposition it offers to its customers -- high-quality diamonds at more attractive prices.

Blue Nile generated about 70% of its 2013 revenue from engagement products such as diamond engagement rings. Most couples are balancing tight budgets for their weddings and tend to be cost-conscious when it comes to items such as engagement rings.

Based on Blue Nile's internal estimates, a typical engagement ring buyer will save up to 50% with Blue Nile in comparison with an unnamed competing retailer (my guess is Tiffany). A one-carat diamond ring costs approximately $6,500 at Blue Nile, compared with a price tag of $12,244 at the competing retailer it surveyed.

While Tiffany's has the magical ability of charging a premium price for the same diamond ring in its distinctive blue box, this doesn't work all the time and with everyone. For a couple preparing for the event of their lives, buying from Blue Nile either means a larger diamond ring at the same price or a more luxurious honeymoon with the resulting cost savings. Moreover, even Tiffany with its premium branding is tapping into the affordable luxury theme by introducing a wider selection of lower-priced items.

One example was Tiffany relaunching its Atlas Collection in September of last year. This collection of rings, necklaces, bracelets, and earrings in rose, yellow, and white gold with diamonds has price points that range from as low as $125 to as high as $25,000, which is significantly more affordable than Tiffany's Yellow Diamonds collection in the $100,000 range.

Source: Blue Nile

Unique business model
Another positive for Blue Nile is its consistent free cash flow. Blue Nile generated positive free cash flow in every single year of the past decade; Tiffany had negative free cash flow in four of the past 10 years. The secret lies in Blue Nile's differentiated business model.

Unlike traditional bricks & mortar luxury retailers, Blue Nile enjoys access to a wide collection of independently certified diamonds without utilizing any upfront capital of its own. With exclusive relationships with certain diamond suppliers it can display their diamond inventories for sale on the Blue Nile website without holding inventory. Blue Nile will only buy the diamonds from its suppliers when a customer orders them. As a result, Blue Nile benefits from negative working capital which drives free cash flow generation; Tiffany typically holds its inventories for more than a year.  

Market potential
As of June 2013, Blue Nile claimed to have a 3.9% share of the $4 billion U.S. engagement ring market, but a 0.8% market share of the $5 billion ancillary wedding bands market and a 0.2% share of the broader $22 billion non-engagement diamond market.

In the past two years, Blue Nile has grown its domestic sales contribution from non-engagement products by 7% from $106 million in 2011 to $121 million in 2013. Looking ahead, Blue Nile has the potential to grow its fashion and non-engagement jewelry business via referrals from its core engagement business customers.

Looking beyond the domestic market, Blue Nile's revenue contribution from non-U.S. markets was $14 million in 2013, which represents 30% growth from $11 million in 2011. In particular, the Chinese market holds much promise for Blue Nile with its propensity toward e-commerce and larger population (and correspondingly greater number of marriages).

According to Bain, the Chinese e-commerce market has grown five times as fast as the U.S. market since 2009. In addition, about 10 million couples get married in China every year, compared with 2 million weddings annually for America. These statistics illustrate Blue Nile's expansion potential abroad.

Foolish final thoughts
Blue Nile delivered an excellent set of results in the first quarter of 2014, growing its revenue and net income by 6.8% and 29.7%, respectively. This strong financial performance further validates my confidence in Blue Nile's affordable luxury investment theme.

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The article Why This Company Is the Best Play on the Affordable Luxury Theme originally appeared on Fool.com.

Mark Lin has no position in any stocks mentioned. The Motley Fool recommends Blue Nile. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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