Stifel Nicolaus analyst Scott Devitt upgraded his rating on Blue Nile (NASDAQ:NILE) to Buy from Hold with a $37 target price (18X 2007 EV/unlevered FCF estimate). According to Devitt, NILE has "outstanding and improving financial metrics" including return on capital, cash conversion cycle, and FCF. Here's his analysis:
The company has a $100 million buyback in place which accounts for more than 17% of the total market capitalization of the business. Also, the company's core business of engagement jewelry, 75% of revenue, is resistant to economic downturns, in our view. In our view, Blue Nile remains a compelling acquisition target. Liberty Interactive, IAC/Interactive (NASDAQ:IACI), and Amazon (NASDAQ:AMZN), remain at the top of our list. Blue Nile continues to manage through a challenging environment for growth. In 4Q, the company experienced higher advertising costs which limited sales growth. In 1Q, the company lowered prices to reaccelerate growth which caused operating income to remain flat with the prior year levels. Recently, the Independent Jewelers Organization, a trade group representing more than 800 small jewelers, introduced IJODiamonds.com. This site allows consumers to select diamonds and have them delivered to a local store for a personal inspection before purchasing. We do not believe this presents a risk to Blue Nile's business model given that it does nothing to address the bloated operating cost structure of small jewelers. We believe Tiffany & Co.'s (NYSE:TIF) recently released 1Q results offer insights to Nile's business and believe the TIF data points to be net neutral as they relate to Nile.
We are upgrading our rating on Blue Nile shares to Buy from Hold and establishing a $37 target price, 18x our 2007 EV/unlevered FCF estimate. The stock has reached a level that makes us much more comfortable entering a position despite near-term fundamental challenges. In our view, the company has outstanding and improving financial metrics – return on capital, cash conversion cycle, and free cash flow.
In 2005, Blue Nile generated a report return on capital of 16%. If one were to remove the excess cash from the business and assume it is returned to shareholders via a buyback, the ROC jumps to 31%. In 2006, the reported return on capital should approach 20% but without the excess cash the ROC jumps to 41%. Given that Blue Nile spends only $2 million per year in capital expenditures and it has no need to acquire like businesses, the major challenge the company appears to be how to efficiently return capital to shareholders in a timely fashion.
The company has a cash conversion cycle (A/R days + INV days – A/P days) of negative thirty-six (36) days. In Blue Nile's diamond segment, the company pays its vendors on terms ranging from 45-60 days and we understand new deals are receiving increasing payment terms given Blue Nile's distinct value proposition to suppliers. Due to the outstanding CCC characteristics of Blue Nile's business, the company is able to generate free cash flow which is almost twice the level of its reported taxed net income. As an example, we expect $30 million in free cash flow in 2006, of which $18 will come from the operations of the business and another $12 million will come from the working capital float, offering the company flexibility in its use of cash and allowing the company to generate rather than consume cash as it grows.
The company has a $100 million buyback in place which accounts for more than 17% of the total market capitalization of the business. Also, the company's core business of engagement jewelry, 75% of revenue, is resistant to economic downturns.
In February Blue Nile announced that its Board of Directors had authorized the repurchase of up to $100 million of the company's common stock over the next 24 months. Through the first reported quarter in which the buyback has been announced, the company has purchased $6.1 million of its stock. We believe the company will fully execute its buyback program over the remaining 22 months of the plan. The $94 million remaining on the buyback amounts to 17% of the market capitalization of Blue Nile.
There has been much discussion lately around whether interest rates will rise or fall, whether we are headed toward stagflation or inflation, whether there may be a double top in the housing market so we can all sell, whether the shopper will hibernate due to high energy costs, whether gold is going to $900 or $1,900 and whether or not growing ethanol-generating corn in one's backyard would meet HOA guidelines. Given the recent focus on inflation and the like, we often wonder where this discussion has been for the past six (6) years, a time in which prices for every need in society have been increasing at a multiple of the so-called core inflation rate. That said, in no instance have we heard the possibility of deferring a marriage due to the issues at the forefront of economic debates in today's uncertain times. Blue Nile generates 75% of its revenue from diamond engagement jewelry, which we believe is well-protected from an economic downturn. In fact, in difficult times, consumers may be more likely to comparison shop for diamond jewelry (a positive for Blue Nile) and it is possible slowing economic growth could cause commodity cost increases to moderate (a positive for Blue Nile).
In our view, Blue Nile remains a compelling acquisition target with names such as Liberty Interactive, IAC/Interactive, and Amazon, at the top of our list.
We are fans of the long-term prospects of the Blue Nile brand. Still, we often believe that Blue Nile would be best situated within a larger retail organization that could allow for the brand to blossom without a need to focus specifically on near-term profits.
Liberty Interactive and IAC/Interactive are both focused on the interactive retailing business and each has shown an interest in acquiring compelling business in the category. At the core, Liberty and IAC's retailing businesses are TV retailing platforms – Liberty owns QVC and IAC owns HSN. Liberty recently purchased Provide Commerce (ProFlowers and other brands) and Liberty also owns 19% of GSI Commerce. IAC recently bought Cornerstone Brands (catalog retail) and Shoebuy.com. The reason we find Blue Nile to be an acquisition candidate for either is not because we believe $6,000 engagement rings would sell on QVC or HSN, it is because we believe both companies are building broad interactive retail brands. Specifically, in the case of Liberty, the company is very comfortable running retail brands separately without integration. As an example, the core QVC demographic is quite distinct from the core ProFlowers demographic. We believe either company owning Blue Nile would allow the Nile brand to grow while not have a public market dissect quarterly profits and there are also at least $3 million of public company costs that could be removed upon acquisition.
To us, the more compelling acquirer of Blue Nile would be Amazon. The benefits discussed above continue to be true but the case for Amazon is much more interesting, in our view. Amazon caters to the Blue Nile demographic and we believe plugging NILE into the Amazon platform would create an immediate branding benefit to the business as Amazon's 57 million customers would be introduced to and would immediately trust in the Blue Nile brand. To be sure, Blue Nile has a strong brand today and receives 30% of new customers via referral but we think that Blue Nile at Amazon would be a material positive for business. Separately and admittedly less relevant, Blue Nile is based in Seattle where Amazon is headquartered, and subleases its HQ on one floor in Amazon's overflow HQ building. Interestingly, today Amazon on the basis of enterprise value (adjusted for NPV of NOL)-to-tax effected free cash flow (unlevered) trades at almost 2x Blue Nile based on our 2007 estimates for both companies.
Blue Nile continues to manage through a challenging environment for growth. In 4Q, the company experienced higher advertising costs which limited sales growth. In 1Q, the company lowered prices to reaccelerate growth which caused operating income to remain flat with the prior year levels.
4Q05 Advertising. During the month of December, Blue Nile experienced a significant increase in online advertising costs with cost per click rates rising by 50% over the prior year. Blue Nile had become increasingly reliant on search traffic given its high profitability in earlier stages of development. As well, Blue Nile lost placement on shopping channels on the Internet given that a competitor outbid Nile last year on the deal. Blue Nile will have the capacity to regain its exposure to branded advertising as contracts are renegotiated in the summer of this year. When communicating with the financial community following the fourth quarter results, the company noted that it would be trying to find alternative marketing channels which may be able to provide more profitable growth.
1Q06 Pricing Lever. The company was able to reaccelerate its growth in the first quarter but the company decided to focus on lowering prices rather than pursuing alternative marketing channels. The company reported revenue for the first quarter that was up by 15% and exited the quarter with 23% growth in March. To attain the growth, the company experienced a gross margin that was 150 basis points lower than the prior year and operating profit that was flat with the prior year despite the 15% revenue growth.
We believe Blue Nile's strategy of lowering prices was the appropriate strategic move and we believe Nile's operating expense structure gives the company greater flexibility than competitors. That said, in our experience with commodity retailers, when the pricing lever is pulled, the stocks don't tend to work until the operating profits begin to grow. We expect Blue Nile will begin experiencing operating profit growth again in 3Q06 and, all else being equal, we believe the 30% pullback in the shares offers a compelling entry point while investors await the improving fundamentals.
Recently, the Independent Jewelers Organization, a trade group representing more than 800 small jewelers, introduced IJODiamonds.com. This site allows consumers to select diamonds and have them delivered to a local store for a personal inspection before purchasing. We do not believe this presents a risk to Blue Nile's business model given that it does nothing to address the bloated operating cost structure of small jewelers.
Blue Nile has an operating expense structure that is 13% of its revenue. Management has stated on several occasions that it believes it can get operating expenses to 10% of revenue over time. Conversely, public company traditional jewelers have operating expenses that are in the mid-40% range as a percent of revenue. We believe the small jewelers represented by IJO have similar operating structures to those of the public company jewelers. In our view, it is not so much the ability to touch and feel the diamond as it is the ability to sell a commodity for 30% less than competitors due to a more efficient operating structure. We find nothing in the IJO offering that corrects the operating structure constraints of small jewelers. As such, we view the launch of IJODiamonds.com as a non-event.
We believe Tiffany & Co.'s recently released 1Q results offer insights to Nile's business and believe the TIF data points are net neutral.
Tiffany noted that the company experienced strength in the $3,000 to $10,000 price range and mixed results at other price levels. Blue Nile has stated that 15% of revenue occurs at a price point greater than $20,000. However, the average engagement selling price is in the $5,600 area in the middle of the strength at Tiffany. Tiffany specifically noted strength in the engagement and silver category. Finally, Tiffany also noted sharply higher precious metal and diamond costs and that the company periodically adjusts retail prices to mitigate such events. The TIF results make us believe headwinds remain for NILE as it relates to commodity costs but competitors raising prices is a positive as well, in our view.
We would Buy the shares.
Blue Nile is a low-cost leader in a commodity industry facing some near-term fundamental challenges that is now 30% off its 4Q05 levels. The financial metrics of the business are outstanding and continue to improve with time, in our view. The company remains an acquisition candidate within the consolidating interactive retailing segment. The company has a buyback program with $94 million of availability over 22 months or 17% of the market cap. For us, given that the shares are now below 14x 2007 free cash flow and below 30x cash earnings, we believe the time to act is now.