It is bad enough that Odimo posted lower sales last year in an industry in which growth is exploding. It is even worse that its operating loss was larger in 2005 than the prior year, and that its reported annual pretax losses nearly doubled. But worst of all, the company received a “going concern” warning from its accountants, which raises substantial doubt about Odimo’s ability to remain in business. 

 

The following analysis reflects troublesome trends for Odimo. Our sources for this information came from publicly available documents generally filed with the SEC, including “fine print” in the attorneys’ exhibits. All opinions, analysis, and conclusions are solely those of the author. 

 

• “Going Concern” Warning by Accountants – Perhaps the most serious problem that Odimo faces is the “going concern” warning, which was issued by its new accountants. This opinion “raises substantial doubt about [Odimo’s] ability to remain a going concern.” The accountants cited continuing losses and negative cash flow, a trend that is expected to continue through at least 2006. If Odimo is unable to raise additional capital, increase revenues, and cut costs, there is substantial doubt about whether the company can remain in business, according to the accountants. It is highly unusual for a company to receive a “going concern” opinion from an accountant, though Sarbanes-Oxley has precipitated an increase in these warnings.   
  
  
• Operating Metrics Unfavorable – Several key operating measures showed an unfavorable trend in 2005. The table below summarizes financial trends. 

• Total revenues were down – For the year, Odimo’s revenues were $51.8 million, down just under 1 percent from the prior year. While Odimo’s revenues were up in the first two quarters, they dropped by 9 percent in the third quarter, and were down a substantial 14 percent in the all-important fourth holiday quarter. 
• Customer traffic down – Across all three of Odimo’s websites, the number of visitors was down 24.7 percent for the year 2005 compared to the prior year.   
• Number of orders down – For the year ended December 2005, Odimo shipped 151,700 orders, down roughly 3 percent from the prior year. The company noted that its average order value was $387, up from the prior year’s $374. However, based on math – $387 x 151,700 – the company should have reported revenues of about $58.7 million, rather than the $51.8 million it actually reported. This could be explained by returned goods (a 12 percent return rate by value); however, management offered no explanation in its legal filings.   
• Gross margin down – For the full year, Odimo’s gross margin was 24.2 percent, down dramatically from 28.9 percent in the prior year. This decline was the result of two factors: 1) an increase in the sales mix of diamonds, which carry inherently lower margins; and 2) the sale of luxury goods – and some discontinued goods at discount prices – on the ashford.com website.   
• Marketing costs up – Marketing costs were 14.7 percent of sales, up from the prior year’s 12.7 percent. Odimo was trying to boost sales.   
• Fulfillment costs rose – As a percentage of sales, order fulfillment costs were 7.0 percent versus 6.7 percent the prior year. This was driven by a product mix shift towards diamonds and fine jewelry, which have higher shipping costs per order.   
• General & administrative costs rose – After eliminating unusual items, Odimo’s general and administrative expenses rose to 21.9 percent of sales versus 18.1 percent in 2004. Insurance expenses, professional fees, and public company costs drove up its operating costs.   
• Operating loss rose – Prior to Odimo’s charge for goodwill impairment in 2005 (see below), its operating cost rose. After eliminating its $4.7 million stock compensation expense in 2004, Odimo’s operating loss rose dramatically, as the following table illustrates.

• Fourth Quarter Results Reflected Unfavorable Financial Trends – For its fourth quarter ended December 2005, Odimo’s sales were down and its operating loss was up over the prior year, as the table below illustrates. 

 

The fourth calendar quarter encompasses the all-important holiday selling period; we would expect Odimo to post its best results during the fourth calendar quarter. Instead, its sales and losses were the worst of any quarter during 2005 and 2004, as the graphs below illustrate.

 

Source: Company reports

 

• Goodwill Impairment Charge Hefty – For its year ended in December 2005, Odimo took a huge charge – $9.8 million – for impairment of goodwill. There was no charge in the prior year. As of the end of the year, Odimo had no goodwill on its balance sheet.   
  
  
• High Public Company Costs – Like most public companies, Odimo continues to cite the high cost of being a public company. These comments would be appropriate coming from a company that had been public for years, and was suddenly experiencing much higher costs of being in the public arena due to tightened accounting rules and Sarbanes-Oxley requirements. However, Odimo became a public company just over a year ago; it should have known that public company costs were soaring; management apparently did not budget appropriately for these costs. 
  
  
• No Income Tax Accrual – Odimo has not accrued for income taxes since inception. Corporations are not required to make a tax accrual until it is reasonable to assume that they will start paying taxes – taxes that would accrue from profits. Because Odimo’s accountants did not require the company to accrue for income taxes this past year, they apparently believe that the company’s prior operating losses, coupled with projected losses, make it unlikely that Odimo will post profits – and pay income taxes – in the foreseeable future.    
   
• Continuing Losses – Since Odimo’s inception in 1998, the company has never generated a profit. Further, management believes that it is likely that Odimo will lose money in 2006. Since it was founded, the company has lost over $92 million, including $23.5 million in 2005 and $12.5 million in 2004.  
   
• Capital Infusion Needed – Management says Odimo needs additional capital to meet future cash requirements and to execute its business plan. Investment capital (equity) may not be available. Likewise, debt financing (bank loans) may not be available, or may have unacceptable terms. Odimo’s management has a list of capital expenditures and marketing expenses totaling $10 million for 2006. It is highly unlikely that this budget could be funded from working capital.  
   
• Bank Loan In Jeopardy – Odimo’s credit facility (secured revolver) expires in July 2006, and all principal and unpaid interest is due. This credit facility allows the company to borrow up to $5 million (at certain times of the year, this increases to $8 million) but it is capped at 75 percent of the value of Odimo’s inventory. All signs suggest that the bank may not renew this loan. 
• Odimo’s “going concern” opinion created default – Under the terms of the bank loan, a “going concern” opinion triggers a loan default, and the bank could have called the loan. However, Odimo was able to obtain a waiver via payment of a fee, an increased interest rate, and agreeing to an amended loan agreement. 
• Odimo’s loan guarantor has set a $2 million limit on borrowings – Softbank Capital Partners, which has a 12 percent ownership position in Odimo, has guaranteed Odimo’s bank facility. Because of Odimo’s deteriorating financial conditions, Softbank says it “prefers” that Odimo keeps its borrowings below $2 million, rather than the allowable $5-8 million (depending on several factors). Further, now that Odimo has returned roughly $4.4 million of inventory to SDG Marketing (see below), it may bump up against inventory limitations on its future borrowing (though it is not clear how much of the returned goods were held on consignment versus owned inventory).  
   
• Investment Bank Hired to Study Alternatives – During the first quarter of 2006, Odimo’s board authorized hiring an investment bank to review strategic alternatives, including sale of the company, a capital infusion, sale of certain assets, or other arrangements to generate and preserve capital.  
   
• Legal Proceedings Against Management – In January, Odimo was served with a complaint (a consolidation of two previously served complaints) alleging that company officers violated the Securities Act of 1933 due to false and misleading statements in public disclosures related to the company’s initial public offering in 2005. According to management, this proceeding has “an uncertain outcome.”  
   
• Stock Price Plummeted – Odimo’s shares came public in mid-February 2005 at $9 per share. Since then, the stock has fallen sharply in price. By the third quarter (less than nine months after it came public), ODMO shares dropped to $1.45; they fell further in the fourth quarter, trading as low as $1.26 (and as high as $2.18). Since the beginning of 2006, ODMO shares have traded as low as $1.25.
   
• Resignation of Accountants – Deloitte & Touche resigned as Odimo’s accountants at the end of August 2005; no reason was given. Since then, a regional firm, Ratline Cohen & Holtz, have begun auditing the company’s books. While all accounting firms follow GAAP practices, there may be some difference in interpretation of those practices. A comparable situation exists among diamond graders: grading standards are clear, but interpretation varies. 

• Termination of Supply Agreement – Odimo had a supply agreement with SDG Marketing, an affiliate of The Steinmetz Diamond Group (including Beny Steinmetz, Daniel Steinmetz, and Nir Livnat). Prior to the company’s initial public offering, Beny Steinmetz, Daniel Steinmetz, and Nir Livnat owned at least 33 percent of Odimo (39 percent based on certain events). Post-offering, it appears that this group owns as much as 22 percent of the company’s stock (at least one stock transaction among the Steinmetz’s occurred late in 2005, but it is unclear if it alters their ownership position materially). Clearly, transactions between SDG and Odimo are between “related parties.” Beny Steinmetz resigned from Odimo’s board pre-offering; however, Lior Levin, who appears to represents the Steinmetz’s interest, remains on the board.   

Under the terms of the supply agreement, SDG supplied an inventory of diamonds to Odimo. The agreement called for SDG to maintain up to $6 million of diamonds with Odimo during 2006. In 2005, 18 percent of Odimo’s diamond sales came from inventory supplied by SDG. According to Odimo, this agreement was cancelled because of the decreasing percentage of diamond sales from this diamond inventory and the greater risks of holding and carrying diamond inventory, some of which was apparently held on consignment. (In separate transactions, Odimo also purchased approximately $1.9 million of jewelry from The Steinmetz Diamond Group in 2005 from its jewelry manufacturing facility in India. These jewelry purchases from Steinmetz represented approximately 38 percent of the aggregate dollar value of all of Odimo’s 2005 jewelry purchases.)

 

As a result of termination of the agreement with SDG, Odimo returned roughly $3.7 million of diamond inventory to satisfy a $3.7 million outstanding payable to SDG Marketing, and it delivered to SDG Marketing about $700,000 of diamond inventory as payment in kind (in lieu of currency) to satisfy another payable to SDG.  

 

As a result of the termination of the SDG supply agreement, Odimo had less than $50,000 of diamond inventory on hand as of March 30, 2006 (its year-end 2005 balance sheet showed $4.1 million in diamond inventory). Odimo now exclusively sources diamonds from various third party suppliers who will generally ship the diamonds to the company in one or two days. 

 

We note that Odimo touted its arrangement with Steinmetz as a positive factor in its initial public offering prospectus last year. “Our supply arrangement with Steinmetz gives us access to this wide selection [of diamonds] at cash market prices. Cash market prices are typically the lowest available wholesale price . . . and reflect a discount of 5 percent – 7.5 percent from prices for diamonds purchased on a credit basis. Under our contract with Steinmetz, however, we can defer payment on diamonds we purchase up to 180 days which substantially reduces our working capital needs.” This quote raises two questions: 1) will Odimo’s gross margin erode because it will not be able to buy diamonds at “cash prices”?, and 2) will Odimo need additional working capital to replace its sweetheart deal of 180 day terms with Steinmetz? 

• Grey Market Problems – About 35 percent of Odimo’s sales are grey market goods. Excluding diamonds and fine jewelry, 70 percent of Odimo’s net sales are from grey market merchandise. Grey market merchandise is purchased in the “parallel” or “grey” market from non-authorized distributors; Odimo is able to buy these goods at lower prices than authorized distributors charge, and Odimo is not constrained by pricing guidelines specified by the manufacturers. Thus, Odimo is able to offer grey market goods at below “suggested retail” prices while maintaining attractive margins. In August 2005, Odimo settled, for a nominal amount, an action brought by Gucci America, which sought an injunction and unspecified damages alleging that Odimo sold counterfeit Gucci goods. There are at least three problems with selling grey market goods:

• Counterfeits Abound – Because much of the merchandise is obtained from grey market sources (which are generally non-authorized distributors), it is often impossible to determine if the goods are real or fake, since the originating paperwork has been removed.   
• U.S. State Laws Regulate Sale of Grey Market Goods – Of 50 U.S. states, 41 have laws regulating how grey market goods may be sold. Most of the watches that Odimo sells come from grey market sources.   
• Stolen Goods Problematic – Odimo is open about its lack of in-house compliance and quality testing for watches. According to the company, “the only procedures we follow to ensure that the watches we purchase are not stolen are that we purchase in significant quantities and we purchase watches only from suppliers with whom we have a pre-existing relationship or to whom we have been referred. Accordingly, we face increased risk that the watches we buy may be stolen or counterfeit because we do not have access to source documentation for our watches.
   
• Loss of Market Share – According to comScore Networks, Internet jewelry sales rose by 27 percent in 2005. Odimo clearly lost substantial market share since its revenues were down 1 percent. 

• Employee-intense business – Odimo now has 113 full-time employees, down from 125 last year (plus three part-time employees). That is good news. The bad news is that competitor Blue Nile generated revenues of just over $200 million in 2005, roughly four times as great as Odimo’s $51 million, with just 133 full-time employees and 13 part-time employees. 

• Unfavorable Comparisons to Other Internet Jewelers – In the past, IDEX Online Research has published comparisons of Odimo to Blue Nile and other jewelers, both selling over the Internet and selling via traditional retail stores. These comparisons generally have shown that Odimo compares unfavorably – especially when evaluating financial benchmarks – to its competition. 

So, was there any good news?

From a financial and business viewpoint, there was little good news at Odimo in 2005. However, we found four encouraging bits of news.

 

·        Average order size increased – Odimo’s average order rose to $387, up 3 percent from the prior year’s $374. This was due to a shift toward diamonds, which carry a larger ticket. The increase in the average order was offset by some price cuts at year end as Odimo tried to move discontinued handbags and close-outs of certain luxury goods. 

 

·        No off-balance sheet items – Management reports that it has no off-balance sheet items. This would include side-letters and other issues that would not normally show up in the company’s notes to its financial report. 

 

·        Capital expenditures roughly equated to depreciation – It is notable that Odimo’s 2005 capital expenditures of $3.4 million were roughly equal to its depreciation of $3.6 million. In short, it did not spend more cash than it had reserved. 

 

·        Year-end cash was notably higher – For its year ended December 2005, Odimo’s cash stood at about $3.8 million, up from last year’s $600,000. However, the bad news is that this indicates that the company has burned through most of the $22.4 million it received from its initial public offering last year. Further, since the end of the year, Odimo has borrowed roughly $1 million on its line of credit; this indicates a high cash burn-rate in the first quarter of 2006. 

 

Is Odimo Going Private?

In our opinion, Odimo could be planning to go private, if it could obtain capital to buy the public shareholders out. We view this as highly unlikely. However, the math makes the transaction attractive. Odimo received about $22.4 million in proceeds from its initial public offering in February 2005. If it could repurchase all 3,125,00 shares it sold to the public for the current stock price (around $1.60 as of the end of March), it would take only about $5 million. Even with all of its problems, there may be investors who would spend $5 million to buy a 44 percent share of $50 million in sales (3,125,000 shares represent about 44 percent of all 7,162,000 shares issued, including to insiders). This same math would apply, should the company be purchased by a third party. 

 

A Potential Bankruptcy?

In our opinion, Odimo could be planning for a bankruptcy. By returning goods and clearing its payables now to SDG, the principals of which have a beneficial ownership interest in Odimo, the company will avoid tying up this inventory, in the event of bankruptcy. Further, by utilizing diamonds as “payment in kind,” it clears additional inventory from the company’s books; this inventory could be made available to all creditors, under the U.S. bankruptcy code. Further, by moving this inventory physically now, Odimo may avoid the appearance of “preferential payments” whereby a bankruptcy judge could demand the return of all payments, either in cash or in kind, that were made in advance of a bankruptcy filing (preferential payments usually occur in the 30 day period prior to filing for bankruptcy, but this period could be extended in the case of related parties). 

 

We note, however, that Odimo management has been very careful to avoid mentioning bankruptcy, especially when listing reasons for hiring investment bankers to evaluate strategic alternatives. In contrast, both Friedman’s and Whitehall Jewellers threatened recalcitrant vendors with bankruptcy. 

 

This analyst can also argue the other side: by using diamonds to repay SDG, it avoids using precious cash. Further, Odimo will no longer tie up working capital by holding diamonds. In addition, we do not see any advantage of filing for Chapter 11 (reorganization) bankruptcy. There is no debt to be restructured, no significant leases to be cancelled, nor other drains on cash that could be terminated. Further, we are unsure how the company could get DIP (debtor-in-possession) financing, especially since it appears that all of the company’s assets are already secured.  

 

If Odimo files for bankruptcy, it would likely be liquidation. In liquidation, current assets would roughly cover current liabilities. There are no long term liabilities; long term assets consist of business equipment rather than valuable real estate. In short, creditors might (and we emphasize – might) get paid off, but shareholders would likely get nothing, in our opinion. 

 

Monday Morning Quarterback’s View

It is easy to sit around after the fact and speculate on what Odimo has done wrong. In our view, there are some glaring errors:

 

·        Odimo should have stayed away from grey market goods – Companies who deal in grey market goods can make great money, but they are viewed as “shady.” Would you buy a diamond from the same “shady” dealer who just sold you a Gucci purse at a deep discount (and you really aren’t sure if the purse is real or fake)?

 

·        Odimo should have focused on diamonds – The action in internet jewelry is in diamond jewelry. Because management had to deal with too many distractions related to its other businesses, it may have missed seeing the opportunity in diamonds. Its original financial backers – the Steinmetz family – are diamantaires; we are surprised that Odimo did not focus on the diamond business. 

 

·        Many other conceptual errors – There were many other conceptual errors along the way. For example, perhaps Odimo should have postponed its initial public offering. It met with delay after delay when it was filed in 2004; final pricing was below the initially projected range, which indicated that the market had some serious questions about the viability of the company. If Odimo had remained out of the public arena, it might have more flexibility – and certainly lower costs – to do what was needed to fix its business. The list goes on and on. 

 

Company Background

Odimo is an online retailer of high quality diamonds and fine jewelry, current season brand name watches and luxury goods. According to company documents, it offers more than 25,000 independently certified diamonds, a wide range of precious and semi-precious jewelry and over 2,000 watch styles from brands such as Tag Heuer, Omega and Movado. In addition, it offers an assortment of luxury goods, such as fragrances and sunglasses, from brands such as Prada, Gucci and Fendi. Odimo sells diamonds and fine jewelry at competitive prices and brand name goods at discounts to suggested retail prices.

 

Odimo operates the following three websites:

• Diamond.com – This website features certified diamonds, fine jewelry, and brand-name watches.
• Ashford.com – Ashford, an acquired website, features luxury products, including watches, fine jewelry, designer handbags and accessories, home accents, fragrances, sunglasses and fine writing instruments. 
• Worldofwatches.com – This website features a large selection of brand-name watches.