Bidz.com: Incredible Discount Provides a Margin of Safety

Since our initial post on 8/10/09, shares of Bidz (BIDZ) are off approximately 35% compared to flat to slightly higher performance for the S&P 500, Blue Nile (NILE), and Amazon (AMZN):

The decline follows lower-than-expected results the same day (after market close on 8/10/09). We previously commented on results and the overall retail sector. While still profitable, revenue was down 51% Y/Y as jewelry remains non-essential and low on the priority list for many consumers. Further, we believe Bidz's business is even more discretionary than the business of Blue Nile and other jewelry retailers that are helped by less discretionary engagement ring sales.

Bidz is not alone in its pain. We are aware of several other discretionary/luxury retailers that suffered large Y/Y revenue declines in the June quarter: Sotheby's (BID) down 48%, Ethan Allen (ETH) down 41% Y/Y, and Nutrisystem (NTRI) down 32% Y/Y. We can even find meaningful Y/Y revenue declines outside of retail: Tyco Electronics (TEL) down 34% Y/Y and Freeport-McMoRan Copper and Gold (FCX) down 32% Y/Y.

We prefer to invest in companies trading a low multiples of earnings with current-year growth, yet sometimes venture outside of this requirement when we find what we believe to be a significant discount to the valuation that would be assigned to a business by an informed private market buyer.

In this case, despite limited short-term visibility and known hair on the story (please see our 8/14/9 post), our BIDZ thesis is focused on the durability and strength of the business model, which we believe warrants a higher valuation and provides a margin of safety at present levels. We believe shares are attractive for five key reasons we discuss in detail on our blog:

1. Jewelry retailing is a good business over time.
2. Difficult-to-replicate franchise with history of profitability and extremely high returns on invested capital.
3. Favorable long-term secular trends.
4. Shareholder-friendly management team.
5. Attractive absolute and relative valuation on current earnings and on normalized earnings power.

Let's again address valuation here (multiples as of 8/21/09):

• Shares of Bidz are trading at six times 2008 earnings and fifteen times our downward revised 2009E earnings of $5.0 million ($0.20 per share) from $8.0 million.

• Although difficult to foresee improved top-line performance and/or multiple expansion in the near-term, we believe BIDZ could fairly trade at 15 to 20 times earnings (5% to 7% yield) given the company’s established, difficult-to-replicate, high-ROIC online franchise. Importantly, we believe an informed private market buyer would award a similar valuation.

• In our initial post, we established a $5.25 - $7.00 (~$6.00 midpoint) fair value on depressed 2009E earnings, which no longer holds given reduced expectations for 2009. However, giving credit for a return to growth and normalized earnings of $12.0 million ($0.50 per share, still below 2007-08 levels) would imply $7.50 - $10.00 per share (~$9.00 midpoint).

• On a relative basis, BIDZ is extremely inexpensive compared to Blue Nile, which trades at 77 times TTM earnings and 53 times consensus 2010E earnings. NILE trades at 42 times TTM EBITDA and 2.8 times sales, compared to 4.7 times and 0.5 times for BIDZ, respectively.

• Blue Nile’s TTM reported operating income of $16 million and 5.6% margin compare to Bidz’s $14 million and 9.3% margin, respectively. On an earnings and free cash yield basis, NILE trades offers current investors only 1.3% and 2.9%, respectively, compared to BIDZ's 11.3% and 22.0%.

• On a TTM operating income to enterprise value yield basis, NILE's yield is 2.3% compared to BIDZ's 20.3%. We prefer to buy companies offering at least a 10% EBIT/EV and FCF yield.

• Even acknowledging lower forward yields and strained American consumers, we find a great level of comfort in BIDZ high TTM earnings/FCF yields (which already include three quarters of intense economic contraction). Although we like Blue Nile's business model and established franchise -- in our view -- NILE's valuation is currently supported by the greater fool theory (with evermore speculative buyers necessary to push shares higher).

• As mentioned earlier, we see Blue Nile’s business as less discretionary than that of Bidz, warranting at least some premium. However, we see no reason why the wide gap should persist over time, particularly if certain Bidz overhangs are removed. We expect NILE’s valuation multiple to compress while BIDZ’s multiple expands.

• BIDZ also trades at a significant discount relative to Amazon and a number of other companies. Even shares of Zales (ZLC) rallied markedly in recent months, yet unlike Bidz, the company carries a heavy debt burden with negative TTM earnings and free cash flow. We include a detailed comparable company analysis on our blog, but include a summary below (click to enlarge - price info as of 8/21/09):

• Finally, we have a recent comparable M&A transaction in the online retail space: Amazon’s purchase of Zappos. Amazon management relayed on the company’s earnings call that Zappos has approximately $635 million in 2008A sales with “a small profit”. Amazon’s cash/stock purchase price of $847 million implies a price to sales purchase multiple of 1.33 times. If we awarded the same multiple to Bidz, the implied share price would be $10.46, or 3.3 times current levels.

Conclusion

Our bet is that Bidz.com won’t forever remain a castaway. Despite all of "the hair" on top of macroeconomic concerns (discussed here), we see an excellent entry point into a high return on capital business with a growing global franchise. Sooner or later, we expect the market will focus on the sustainability and earnings power of the company’s business model, likely eliminating the margin of safety that exists for buyers today.

Disclosure: Long BIDZ.

Comments

[darkvill:]

Excellent analysis. You mention a shareholder friendly management team - the founders own 50% of the shares outstanding! With a 10M share float and some good results, BIDZ could easily boast a NILE like valuation.

Aug 27 09:46 AM

[mals:]

The author failed to comment on the pending class action suits against BIDZ

Aug 27 09:59 AM

[Jeffrey Wal...:]

Hi mals,

Can't ignore risk factors -- referenced in text above referring readers to earlier post: "In this case, despite limited short-term visibility and known hair on the story (please see our 8/14/9 post)." Link is here:
commonstocksense.blogs...

Impossible to know outcome, but there are mitigating factors and the suits appear to be bandwagon suits that are common whenever a share price declines substantially. Regardless of outcome, business model should remain intact and profitable.

Jeff

Aug 27 03:45 PM

[seasaw:]

At best, I would entitled this article "BIDZ: a speculative gamble". There is not enough information to conclude that this company is selling at a discount given the number of issues raised by different parties. Furthermore, I do not believe that it has been established taht BIDZ's business model is of such durability and strength that it deserves a premium valuation.
Specifically these are (the author identifies most of these):
1. The SEC is investigating inventory practices;
2. The FTC is investigating the marketing practices;
3. A flurry of lawsuits against the company.
4. Insider selling (wsj reports >900k in last 12months)
5. Problems w/ management/director relationships (unspecified)
6. Concerns surrounding competition (unspecified)

Also, an article indicates that the Better Business Bureau gave the company an "F" due to customer complaints. And, the article states that Saied Afrarmian, the manager and co-owner of the BIDZ's main supplier, Los Angeles Jewelry Production, Inc., served 2 years in state prison in the 1980s for receiving stolen property and was accused in a 2006 civil suit by a jewelry wholesaler of staling jewelry. (see the article at the.honoluluadvertiser...)

Also, an internet search reveals numerous posts can be found about customer complaints and accusing BIDZ of fraud and scams.

The investigations by the SEC and FTC, the shareholder lawsuits, the Better Business Bureau rating and the customer complaints all raise concerns about the practices of the company, particular if you believe the adage that where there is smoke, there is fire. If any of the allegations are true, it raises the question of whether there are any other practices of the company that are questionable that have not been revealed.

Extensive insider selling is generally considered a reason to sell, not to buy, as it is presumed that insider would be more likley to keep or add shares if they thought the prospects of the company were good. If any of the allegations against the company are true, that might provide motivation by insiders to sell.

Stock repurchases used to be considered a good thing, based on the view the company was buying the stock because it was selling below its value. However, the view of stock repurchases has become more ambiguous, as companies caught on and started buying stock to prop up shares prices. Managements motivation to prop up shares prices can be increased when extensive insider selling is occuring. Thus, it is questionable to just assume that management is not so foolish to be buying stock if there is any material risk existing in the companies prospects.

The statement that management is shareholder friendly/oriented is conclusory and without support. I would need much more evidence and examples to make such a conclusion. It is questionable to assume that management is shareholder friendly/oriented merely because it owns a lot of shares, particularly when it is extensively selling shares.

Finally, I cannot agree with the main thesis that BIDZ has a durable and strong business model, warranting a higher valuation and providing a margin of safety at present levels. Perhaps the unspecified concern about competition is a reference to others disagreeing with this thesis as well. The author admits the company is not cheap enough normal valuations as to interest him in an investment, but indicates that his investment is due to BIDZ deserving a premium valuation due to the durability and strength of its business model.

The doubts about the durability and strength of the business model arise from concerns that it may be difficult for BIDZ to retain the current level of business or to increase its business for a number of reasons.
1. The indications from the Better Business Bureau's "F" rating and reported customer complaints, if true, create a concern that customers will migrate to competitors and that potential customers will be dissuaded from using BIDZ.
2. The author indicates that in industries like this, the largest competitor tends to defeat the smaller, me-too enterprises. Here, BIDZ is, according to the author, not the largest. Consequently, the largest competitors may gain market share on BIDZ and squeeze it out.
3. On the other hand, the industry could become more competitive and fragmented as other online retaliers may decide to add jewelry to their sales products and brick and mortar jewelry retaliers may focus on developing or increasing internet sales. The barriers to entry are small - it is cheap and easy to add jewelry to your products and it is cheap and easy to put up a website selling jewelry if you are a brick and mortar enterprise. These companies may be able to provide superior products and services to BIDZ.

While a few internet sellers have been able to establish a durable and strong business model, the internet in general has been more of a benefit to consumers, resulting in lower margines and more fragmentation in most business. Amazon and E-bay are examples of the strong model, although e-bay has been deteriorating as of late. Byeond that, there have been few that have clearly established the durable and strong business model that the author describes.

In conclusion, BIDZ appearsto represent a speculative gamble that the problems with the company, on balance, will be resolved in favor of the company and that its business model will turn out to be durable and strong. However, little evidence is presented to support a high likliehood of these conclusions, thus casting doubt on the conclusion that BIDZ is selling at an incredible discount providing a margin of safety.

Aug 28 09:18 PM