Scott Devitt On Blue Nile's Strong Quarter (NILE)

From Stifel Nicolaus analyst Scott Devitt's note to clients on Blue Nile Inc.'s (NILE) Q1 results (see also full conference call transcript):

Summary
We rate shares of Blue Nile Hold. We like the management, the franchise, and the cash-generating characteristics of the business. As of yesterday's close, NILE was trading for 15x FCF, 22x cash operating income, and 33x cash EPS on our 2007 estimates. We believe the market to be appropriately pricing the shares at current levels.

Blue Nile reported 1Q06 revenues of $50.7 million and EPS of $0.13 including stock comp expense, compared to our estimate of $49.0 million in revenue and $0.11 in EPS. TTM free cash flow increased 53.9% year/year to $29.6 million. We expect full-year 2006 free cash flow in the range of $25 million.

Gross margin in the quarter came in at 20.5% slightly below our estimate of 21.9%. The decrease in margin is attributed to the increase in metal prices, as well as the decision to lower diamond pricing.

For full year 2006, management expects net sales to be between $230 million and $245 million with net income per diluted share of $0.64 to $0.72. These EPS figures include the impact of FAS 123R, which would equate to about $0.14 to $0.16 per share.

Our Thoughts
Blue Nile reported first quarter results that beat our expectations on both top and bottom line. During the quarter, the company decided to implement price decreases rather than spend incremental dollars on advertising, thus passing savings directly to consumers. Also, NILE was impacted by the continued increase in commodity prices in the quarter, which the company did not pass onto its customers. It was impressive that management was able to react to the changed marketing environment so quickly and implement pricing adjustments to reaccelerate growth. Revenue growth in the quarter increased to 14.9% YOY compared to 13.4% growth in 4Q05, and the midpoint of guidance implies full-year revenue growth in 2006 of 17%. We should note that Blue Nile's gross profit margin declined from 22% in 1Q05 to 20.5% in 1Q06 so the price adjustments did not occur without impact on the business. In the quarter, gross profit grew by 7% YOY and cash operating income was flat with 1Q05.

We continue to expect $30 million in free cash flow in 2006 and $36 million in 2007. On 2007 estimates, NILE trades for 15x FCF, 22x cash operating income, and 34x cash earnings. We believe the strategy of lowering pricing is working and we believe Blue Nile is well-positioned to benefit from this change given its low operating cost structure versus traditional jewelry retailers. We would be opportunistic buyers of NILE shares, all else being equal, as we believe this company has solid management and a unique business offering only to be offset by a market that is pricing in general agreement with our belief structure.

Results
Blue Nile reported record 1Q06 net sales of $50.7 million, versus net sales of $44.1 million in the 1Q05, an increase of 14.9%. Income before income taxes decreased 10%, to $3.65 million, compared to $4.065 million in the year-ago quarter. Net income in 1Q06 was $2.4 million, or $0.13 per diluted share including the effects of FAS 123R. Net income per share would have been $0.03 higher excluding the effects of stock comp. We had projected net sales of $49.0 million and diluted EPS of $0.11, or $0.15 excluding stock comp expense.

International business amounted to roughly $1.4 million in net sales. Gross profit in 1Q was $10.4 million, up 7% over the year-ago quarter. Gross margin for the quarter was 20.5%, compared to 22.0% in the year-ago quarter. The decrease in margin is attributed to the increase in metal prices, as well as the decision to lower diamond pricing. Stock based comp expense was $880,000 in the quarter, of which $810,000 was an incremental expense related to FAS 123R. Management noted that non-engagement products continue to grow faster than engagement products.

TTM free cash flow for the quarter was $29.625 million, up 53.9% from the year-ago period, while net cash from operating activities in 1Q06 grew to $31.1 million from $21.1 million in 1Q05. Capital expenditures during the quarter were $608,000. Blue Nile ended the quarter with approximately $89.7 million in cash and equivalents on the balance sheet. The company also announced that it repurchased 187,400 shares during the year for $6.1 million, and also announced that since February 2005, the company has repurchased 752,575 shares of its common stock, or 4% of outstanding shares.

Metrics

* For the quarter the average order size was $1,483, up from $1,415 last quarter.
* Total orders increased 12.1% year/year
* Marketing as a percent of sales remained at about 4%
* Ending inventory for the quarter was $13.7 million, up from $11.8 million at the end of 2005
* Inventory turnover for the TTM was 15.1x, compared to 16.6x in the year-ago TTM

Projections and Conclusion
For 2Q06, management expects net sales between $51 million and $54 million with EPS between $0.11 and $0.12. For full year 2006, management expects net sales to be between $230 million and $245 million with net income per diluted share of $0.64 to $0.72. These EPS figures include the impact of FAS 123R, which would equate to about $0.14 to $0.16 per share. Additionally, the company expects to spend between $2.4 million and $3.0 million in capital expenditures during 2006. In addition, the company will become a cash tax payer in 2006.

Our 2006 cash EPS estimate has been raised from $0.81 to $0.83 with GAAP EPS (including FAS 123R stock option expense) going from $0.65 to $0.69. Our 2007 revenue estimate is $273.5 million with unchanged GAAP EPS of $0.84 and cash EPS of 1.00. We rate shares of NILE Hold.

Our 2006 cash EPS estimate has been raised from $0.81 to $0.83 with GAAP EPS (including FAS 123R stock option expense) going from $0.65 to $0.69. Our 2007 revenue estimate is $273.5 million with unchanged GAAP EPS of $0.84.