Four Factors Guiding Blue Nile's Price Range

Please note that you can click through the charts and diagrams to see larger versions.

After the Blue Nile, Inc. (NILE) conference call this past Wednesday (Seeking Alpha Transcript), I am following up to my prior article where I stated that:

With this backdrop and assuming that the S&P remains within a range of 800 – 950, I expect Blue Nile stock to trade within a range of $20 – $25.

Blue Nile's stock closed on Friday at $21.22.

In my prior article, I gave analysts expectations for the quarter:

• Average Revenue Estimate (Current Quarter): $94.84M;
• Average Revenue Estimate (Current Year): $304.35M.
• Average Earnings Estimate (Current Quarter): $0.36; and
• Average Earnings Estimate (Current Year): $0.87.

How did Blue Nile actually perform?

• Revenue (Current Quarter): $85.8M;
• Revenue (Current Year): $295.3M.
• Earnings (Current Quarter): $0.24; and
• Earnings (Current Year): $0.75.

Blue Nile missed on both revenue and earnings, yet its stock held up. Moreover, the markets were weak with the S&P closing on Friday at 770.05.

Given that backdrop, how do I feel about Blue Nile stock price now? I am reasonably comfortable sticking with my prior estimate that the stock price should remain bound by $20 – $25 so long as the S&P remains in the 800 – 950 range. There are four inputs or factors that guide me to this price: one, decimation of the competition; two, current state of the economy, with emphasis on unemployment; three, the impossibility to define a stock valuation rigorously; and four, recent stock prices. Let's look at each of these four items separately to see how they collectively help to form my opinion that NILE should be range-bound between $20 – $25.

In my last article, I referred you to The Wall Journal article No Sparkle for Jewelers on Feb. 14: Recession Pummels Chain Stores as More Buyers Turn Their Back on Bling (subscription required) published on 12 February 2009.

The recession pummeled jewelers hard during the holidays, when usually they earn an average of 30% of their annual revenues, as consumers avoided gems and other premium goods. Sales of luxury items, including jewelry, fell 34% compared to a year ago, according to MasterCard SpendingPulse.

...

Hopes that Valentine's Day, the third-biggest holiday for jewelry sales after Christmas and Mother's Day, would put some sparkle in results are fading. But Market researcher IBISWorld Inc. said it expects jewelry sales for the Feb. 14 holiday to fall 5.1% to $1.48 billion from $1.56 billion a year ago.

Of course, even before December's poor sales, local jewelry stores and regional and national chains had been disappearing at an alarming rate. For all of 2008, 1,140 jewelry businesses closed -- more than half of them retailers -- and the number of bankruptcies rose 19%, according to the Jewelers Board of Trade, a Rhode Island-based credit research and collections bureau for the jewelry industry.

I can only begin to imagine the chaos and mayhem occurring at competitors' offices—executives scurrying about trying to see which leases they can break, how to cover upcoming debt payments, who ordered expansion into what markets and why, and on and on. None of these actions increases the value proposition to the customer.

Now, compare the competitors' situation with that of Blue Nile's. Look at the chart below to see its revenues during the past nine years.

I am going to discuss this chart again later. The reason for showing this chart now is to demonstrate that Blue Nile is still enjoying reasonable revenues.

Blue Nile has no debt, no massive infrastructure to support, and reasonable revenues. Yes, its revenues were a bit light. Its revenue growth against that of its competitors' remains favorable. So while the competition is in crisis mode, Blue Nile's management team is able to focus on its customers and increase the value proposition.

Let's move along to the state of the economy. While much has been written and continues to be written, one graphic below, a heat map of the unemployment by county, sums it up for me. This graphic is sourced from the United States Department of Labor: Bureau of Labor Statistics.

The above picture is likely to get worse before it gets better. I find the revenue chart and unemployment diagram interesting. Obviously, as unemployment rises, jewelers will be under even greater pressure than they are now. The unfolding of the unemployment picture deserves careful monitoring.

Next, let's discuss the inability to define a stock price rigorously. We have already discussed the revenues and unemployment rates across counties. What's a forecast for this year's revenue? Next year's? When will revenues resume their upward growth? At what rate? For how long? What will the competition look like at the end of this recession? How deep will the recession be? Will we see double digit unemployment values? Where will the unemployment be concentrated and for how long? You can knock yourself out trying to answer these questions. They are unknowable. All that we do know is that this recession is mean and ugly. Beyond that, we're groping in the dark.

If we are groping in the dark, how do we employ a reasonable discounted cash flow model or use any other analytical tool with precision? The answer is, we can't.

And finally, let's look at the past year's Blue Nile stock price chart. Using Yahoo! Finance, I created the price chart below.

As we see from the chart, the stock appears to have bottomed at around the $20 – $25 level. This is after investors have realized that we are in for a difficult economic period.

Earlier I mentioned that the decimation of the competition, unemployment, inability to define a stock valuation rigorously, and the recent stock prices were all inputs into my loosely defined range of $20 – $25 price target. In my view, there are simply too many important unknowns to have high confidence. With the current economic situation, you could dream up any number of possible valid scenarios to justify any price you wanted. That exercise, however, is wasted energy. When the economy does finally turn around, Blue Nile should move up sharply from here.

Before closing, I am going to address two items raised by the bears. First, the price-to-earnings multiple is high. My response, of course, is it is. We're in the depths of a recession. Try to determine what the normalized earnings are with a realistic growth rate (good luck in that exercise) and then we can talk. As I have already indicated, I believe it is impossible to come up with a reasonable forecast. Next, web traffic has come way down and thus the company is likely to suffer. Media Tech Analyst writes in his article:

Traffic to the site was down in the single digits YoY according to management, which materially conflicts with the 40% YoY decline reported by comScore.

According to Seeking Alpha's transcript, Diane Irvine said:

Yes, I don’t think we give a lot of color on that. But I would say in Q4, we saw declines in traffic but those were modest declines, certainly in single digit levels in terms of traffic unlike some published reports but I think had at minus 40% decline or something in traffic.

Marc Stolzman, CFO, elaborated on Irvine's comment:

And so the flip of that – the extension of that conversion is off slightly and when I talked to other people in E-commerce [they] are saying the same thing. Consumers are – traffic is difficult but conversion is the bigger pieces of puzzle where consumers are coming and looking and shopping but don’t necessarily have the courage to pull the trigger and follow through on the purchase.

On an apples-to-apples thirteen week comparison, this year's revenues were 73.2% of last year's revenues. If we accept Stolzman's comment that conversion was down, then obviously third party comments on traffic being down 40% is just plain nuts. Moreover, Irvine is on the record indicating single digit level in reduced traffic. Traffic levels are easily verified, and thus I have every confidence that Irvine was truthful and honest in her comments.

Given the unemployment picture, I am surprised that traffic is down less than 10%. Just imagine when things improve and the competition is even weaker than it is now.

In summary, there are too many significant unknowns to have a confident estimate of Blue Nile's share valuation. We do know, however, that the competition are having an extraordinarily difficult time. We also know that Blue Nile's revenues, while down, are reasonable in the face of current unemployment. The unemployment picture itself remains difficult to forecast. In light of all the economic turbulence, Blue Nile's stock appears to have found a bottom near the $20 – $25 mark.

Disclosure: I am long Blue Nile stock.

Comments

[Joe Friday:]

Your article omits a few salient facts.
1. They withdrew guidance. A clear indication that they believe that trends are worsening. The retail environment is terrible, and Nile is not immune to the economic reality of the moment.
2. They indicated in the cc that sales in the currnet quarter are trending off 15% already, and in my view they are likely to get worse before we see any improvement. In the first q of 2008 their gross revenues were 70M. That would indicate they are trending towards gross revenues of approx 59.5M for this quarter.
3. Their gross margins for the last quarter and the last year are about 21%, resulting in expected gross profits for the current q of about 12.4M.
4. S G and A last quarter was 12.4M, and that should be very close to the current overhead run rate.
5. At a revenue run rate of 59-60M they break even! That is what the facts provided during the cc would indicate.
6. Any deterioration from a revenue run rate of at least 60M/q will result in losses.

Turning to their balance sheet, it is important to note as follows.

1. Although they ended the December q with 54M in cash, they also had 63M in trade payables!!
2. In addition, their inventories were 19M at the end of the q, a decline of about 10% from the prior year, though revenues for the q were down 20%.
3. Current assets exceeded Current liabilites at the end of the quarter by only 8M. They don't have much on the balance sheet other than current assets and libailbities. Book Value, if you accept all values as accurate was 19M at the end of the quarter.
4. There are just under 15M diluted shares outstanding, resulting in a stated book value of 1.26/share. Any write down of inventory or fixed assets would reduce that number further.

At current trading levels the stock is trading at almost 17 x book!
At current trading levels, the stock is trading at an infinte p/e. there is no "e".
Management will not have the cash resources to support the stock price for much longer. Note they used their cash to buy back 66M worth of stock in 2008 (it appears they reduced the diluted share count by 2M shares for an average of about 33/share). Without the management bid in the market, the only other logical source of support is short buy backs. Once they dissipate, the stock should descend.

Given these facts, it is very hard to understand how anyone, let alone someone who is employed as an analyst could recommend this stock.

Feb 23 01:33 PM

[Kevin Stecyk:]

::: 1. They withdrew guidance. A clear indication that they believe that trends are worsening. The retail environment is terrible, and Nile is not immune to the economic reality of the moment.

Agreed, but so what. That's already known. Moreover, would any guidance by any jeweler be credible?


:::2. They indicated in the cc that sales in the currnet quarter are trending off 15% already, and in my view they are likely to get worse before we see any improvement. In the first q of 2008 their gross revenues were 70M. That would indicate they are trending towards gross revenues of approx 59.5M for this quarter.


Only 15% down is darn good, no? How are their competitors fairing?


::: 3. Their gross margins for the last quarter and the last year are about 21%, resulting in expected gross profits for the current q of about 12.4M.


And what's the gross margins for their competitors? Not even close to 21% Just a guess, Blue Nile will become a stronger competitor.


4. S G and A last quarter was 12.4M, and that should be very close to the current overhead run rate.

12.4M is correct for SG&A for the last quarter. Could SG&A be reduced if sales were reduced? Absolutely, just look back to 2006. Then Revenue was $203M, SG&A was $27.1M or $7M per quarter. So we know that SG&A is not fixed.

::: 5. At a revenue run rate of 59-60M they break even! That is what the facts provided during the cc would indicate.

A quote from the conference call relating to break-even cash flow (as opposed to earnings):

Diane Irving...

"And I would say, while it’s difficult to give a number, I think you would be looking at positive free cash flow for the year if the sales are north of say $230 million something like that."

So your numbers are not far off the mark.

The question you have to ask yourself is, if Blue Nile has a large drop-off in sales, what happens to its competition? Won't they be in even worse condition? And does that leave the Blue Nile stronger relative to its competition when the economy does improve?


:::6. Any deterioration from a revenue run rate of at least 60M/q will result in losses.

That's the definition of break-even as you expressed in point five?


:::1. Although they ended the December q with 54M in cash, they also had 63M in trade payables!!

At Dec 30, 2007, the company had about $123M in cash and cash equivalents, and $86M in Accounts Payable.

At Jan 4, 2008, the company had about $54M in cash and cash equivalents, and $62M in Accounts Payable.

Quote from Marc Stolzman during the conference call:

:::For the full year 2008, we purchased 1.6 million shares for $66.5 million representing approximately 10% of outstanding shares at the beginning of 2008.


So what's the problem? A/P has gone down along with sales. If you were to add back the share buyback to the cash position, the company would have about $120 million in cash again. The company decided to spend some of its cash on shares.


:::2. In addition, their inventories were 19M at the end of the q, a decline of about 10% from the prior year, though revenues for the q were down 20%.

Their inventories are rather lean compared to traditional brick and mortar retailers? And Blue Nile can simply hold back on reordering to bring inventory back in line?


:::3. Current assets exceeded Current liabilites at the end of the quarter by only 8M. They don't have much on the balance sheet other than current assets and libailbities. Book Value, if you accept all values as accurate was 19M at the end of the quarter.

First, I place little value on book value, pun intended. Book value has many issues associated with it. I encourage you to read "The Essays of Warren Buffett: Lessons for Corporate America."

With regard to current assets and current liabilities, the company could have chosen to not buy back its shares, which in hindsight would have been a better choice, and had even more current assets. However, it chose a different path.

As far as having little physical assets, would you prefer that Blue Nile be saddled with a lot of unproductive leases in various malls across the world that are unable to turn a profit? Capital light is a beautiful thing.


:::4. There are just under 15M diluted shares outstanding, resulting in a stated book value of 1.26/share. Any write down of inventory or fixed assets would reduce that number further.

As we discussed, its inventory is light compared brick and mortar. The company's inventory doesn't age like that of its competitors. What's the turn rate on its inventory? Do you think it is over 12, implying that inventory lasts less than month? Do you really think its inventory will suffer a massive devaluation when it enjoys a rapid turnover?

And we just finished discussing fixed assets. There are few fixed assets, a wonderful thing in this environment.


:::At current trading levels the stock is trading at almost 17 x book!

Again, don't care about book value. So what?


:::At current trading levels, the stock is trading at an infinte p/e. there is no "e".

We will see about the no "e." Riddle me this: would you prefer to be leading Blue Nile or one of its traditional brick and mortar competitors? Who do you think will emerge from this recession in a relatively stronger position?


:::Management will not have the cash resources to support the stock price for much longer. Note they used their cash to buy back 66M worth of stock in 2008 (it appears they reduced the diluted share count by 2M shares for an average of about 33/share). Without the management bid in the market, the only other logical source of support is short buy backs. Once they dissipate, the stock should descend.


As I write this message to you, I note that it is another brutal day in the markets, with the S&P down 3.3% and Blue Nile up 3.9% to about $22.05.

I am comfortable with my long position, are you comfortable with your (short) position?


:::Given these facts, it is very hard to understand how anyone, let alone someone who is employed as an analyst could recommend this stock.

Who said I was recommending it? Go back and read my two recent articles. I merely stated that I believe Blue Nile will hover around $20-$25 so long as the S&P remains in the range of 800-950. At present, the S&P is about 744, and Blue Nile is still north of $20. So far, I think I've done rather well. The bears, on the other hand, were hoping for a plunge after the latest earnings release.

Thank you for your comment, and I wish you happy trading or investing.

Feb 23 03:28 PM

[Kevin Stecyk:]

:::"As far as having little physical assets, would you prefer that Blue Nile be saddled with a lot of unproductive leases in various malls across the world that are unable to turn a profit? Capital light is a beautiful thing."

I wrote the above paragraph in my earlier response. A lease is an operating cost (operating lease).

So I should have written, "As far as having little physical assets, would you prefer that Blue Nile be saddled with a lot of physical infrastructure (Property Plant and Equipment) with large buckets of local inventory as each location?"

Feb 23 07:01 PM