Google: “Thesis Schmesis”

Far and away the most interesting—and meaningful—conference call I’ve listened to the last couple of weeks was the Blue Nile on Tuesday night.

Blue Nile is what investors like to call “a nice little company”—with good sales growth, healthy margins, actual earnings, and real free cash flow.

Blue Nile also happens to be an internet retailer (of jewelry), and it learned about real free cash flow the hard way, having started up during the internet bubble and survived the internet crash thanks to the extreme diligence and sharp focus of its founder, Mark Vadon.

Unlike, say, Overstock.com, whose CEO went out and bought $7 million worth of diamonds and cobbled together a clunky “Design Your Own Jewelry” site to attempt to sell the stuff, Blue Nile operates as a virtual jewelry store with a terrific, user-friendly site and a well-developed supply chain. Gross margins are half the brick-and-mortar model—but because Blue Nile carries almost no finished inventory and gets paid via credit card before whatever it sells (usually an engagement ring) is assembled and shipped, it generates good margins and real free cash flow that piles up on the balance sheet and goes into share buybacks when the stock gets beat up, as it occasionally does when the company misses quarters, which it occasionally does.

As it did this week.

Being an Internet pioneer that survived the bust, Blue Nile has also witnessed the rise of the Google/Overture keyword advertising model, whereby advertisers buy “keywords” and then pay Google or Overture (now Yahoo!) every time a user “clicks-through” the ad that pops up during a search of those keywords.

And ever since Google came public, Blue Nile has been answering questions about click fraud, cost-per-click and Microsoft’s intentions in the space, always reaffirming the value of keyword advertising to Blue Nile’s business model.

Just last November, Vadon told analysts the following:

And what we really have to do is not go out and run television commercials like an Overstock.com, but what we need to do is stay focused on delivering a great experience and let the market mature and let people grow comfortable with the Internet. If we do that, I think you’ll see us continue to grow at the rates we’re growing now for at least five more years. But that was then, and this is now. Blue Nile missed its fourth quarter revenues and earnings by a wide mark, in large part owing to higher search-related marketing expenses. Specifically, Vadon said the following:

During December, we saw extremely aggressive increases in the cost of online advertising. Our cost per click on Google, for example, rose by over 50% from a year earlier. While the cost of online marketing grew significantly in Q4, we remain disciplined in our spending, in order to maintain profitability on new customers rather than to chase unprofitable growth, as some of our competitors have done. If this sounds familiar, it should be. In “The Most Interesting Press Release You Didn’t Read” I highlighted comments from FTD Group in late December, which said essentially the same thing.

When asked for specifics, Vadon discussed “irrational behavior” in Google search pricing:

To give you perspective, in our top five keywords, our cost per click was up over 80% compared to a year ago. To us, it looks like, frankly, some irrational behavior in the marketplace. I think, if you follow our business, you know that we monetize Internet traffic for jewelry better than anybody in the world, and if we are getting nervous about the pricing of search, it means there’s some people out there who are deficit spending and perhaps are back to the mentality of 1999…. As far as who is out there bidding, it’s slightly different in Q4 as opposed to Q1. I think in Q4 — you asked about Amazon. We haven’t seen them at all in the online search market. We saw a couple larger players; I think Zales was pretty aggressive, Macy’s was pretty aggressive. And then we see just a tremendous number of small players, and these are very small companies. And they don’t play for very long. They will come into search for a week or a couple weeks. And I think there’s just a lot of — and then I think they burn through their budget fairly quickly and fall off the screen. But we just saw a lot of those types of players coming out. The problem is not limited to the cost of keywords themselves: it extends to the diluted quality of the internet users clicking through to the Blue Nile web site, following Google’s move last summer to place more paid ads per search:

So an important matter is how well you can convert. Over time from search, we see slight declines, and it’s not tremendous but slight declines in the conversion rate. I think, to some extent, that has to do with the search engines placing more ads. So, when you went to a search term a year ago versus going to it today, you are going to see more paid search placements today than you did a year ago. Furthermore, as more companies advertise on search engines, the value of the incremental customer is dropping:And as there’s more people there competing for the same traffic, if one consumer is shopping — so if you’re shopping for a plasma TV, you are probably going to go to many merchants, or at least a handful of merchants, before you make your purchase. And so you will be clicking on multiple ones of those, but only buying one plasma screen. And the more paid placements there are, probably the more click-throughs you’re going to have.So what that results in for merchants is downward pressure on the value of those customers Having always thought highly of the Blue Nile CEO and his company’s business model, I’d say something has changed, quickly and significantly—in ways not discussed on Google’s own quarterly earnings call last week.

This is most apparent in the fact that Blue Nile, which has almost exclusively marketed online, is, like FTD Group, considering a shift away from online search:

Given these results, we will be looking to broaden our marketing efforts beyond search in the future. As we seek alternative marketing vehicles to complement our efforts in paid search, I would expect growth to be relatively conservative as we ramp our efforts toward broadening our marketing outreach. This is the right long-term solution for our business. As I’ve stated before, throughout all of our marketing efforts, our focus is on the maximization of gross profit contribution, in keeping with our overarching objective of free cash flow generation…. So what that results in for merchants is downward pressure on the value of those customers. So just as bidding is going up, you’re seeing downward pressure in conversion. Again, this points to our desire in the channel to be less aggressive with our bidding. And if that means giving up some volume to other people who perhaps are not measuring that and doing that ROI calculation, as well, we will do that until it rationalizes somewhat. I’ll be the first to say I didn’t expect to hear comments like these for another year or two. Just two weeks ago (“Google: ‘Our Thesis is Still Intact’“) I reported that various sources within the corporate Google-using community, with one exception, saw no FTD Group-style slow-down in their marketing spend on paid search.

But with Blue Nile easing off the Google search pedal, it looks like the internet search market is indeed rationalizing—not because of Microsoft and not because of click fraud, but because of good old-fashioned free markets.

And it’s happening now, in Internet Time.

Jeff Matthews I Am Not Making This Up

© 2005 Jeff Matthews

The content contained in this blog represents the opinions of Mr. Matthews. Mr. Matthews also acts as an advisor and clients advised by Mr. Matthews may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Matthews’ recommendations.