NILE Shares Approaching Target Valuation; Recommend Buying On Weakness

Caris & Company analyst Tim Boyd addresses clients on Blue Nile, Inc.'s (NILE) likely earnings for 3Q06, as well as on the company's prospects for the 2006 holiday season. His note follows:

NILE shares are up 25% since we initiated coverage with a 2*/Above Average rating on June 1st and up 54% since the company reported a Beat & Raise June quarter on August 1st. Our target valuation for the shares is $40, which implies less than 10% upside from current levels. Nevertheless, we are maintaining our 2*/Above Average rating for the following reasons:

1. Strong current fundamentals. In 2Q06, NILE’s Y/Y revenue growth rate doubled, rising to 30% from 15% in 1Q06. NILE’s Y/Y pro forma EPS growth rate also jumped considerably, rising to 38% from 12%. NILE’s EBITDA margin rose 90 bps sequentially to 8.7%, a stat which we found particularly impressive considering the 60 bps sequential drop in the gross margin. Perhaps most importantly, NILE continued to generate free cash flow at an extremely high rate – it converted 142% of its EBITDA to FCF in the June quarter. At the margin, NILE boasts one of the strongest fundamental outlooks among small-/mid-cap Internet stocks – this continues to be our #1 reason for favoring the shares.

2. QTD traffic patterns indicate potential for solid unit growth in 3Q06. As in 2Q06, NILE’s absolute traffic levels in 3Q06 are tracking lower on a Y/Y basis. This is due primarily to more targeted marketing efforts – in other words, there are fewer visitors to NILE’s site, but the quality of these visitors is higher, as evidenced by the significant improvements in visitor conversion (i.e. visitors who actually end up making a purchase) that we have seen YTD. Assuming a typical seasonal drop in visitor conversion during the September quarter, the available QTD traffic data suggests that our estimate of 26.1k units, or 10% Y/Y growth, is quite reasonable and perhaps even a bit conservative.

3. A less sanguine pricing environment for precious metals and diamonds should relieve some of the pressure on NILE’s gross margin. Gold, silver and platinum prices have been weaker than last quarter – given the fact that these are direct inputs to NILE’s COGS and that NILE’s gross margin hit an all-time low last quarter, we view this as a positive development. Although it is much harder to get a handle on diamond prices, the sense we have garnered from speaking with our industry contacts is that diamond prices have been flat to slightly up this quarter. That having been said, we expect NILE’s average order size to rise 19% sequentially due to the typical September quarter mix shift toward higher price point items.

4. NILE appears to be well-positioned for the all-important Q4 holiday season. Given NILE’s very strong 2Q06 results, our expectations for solid September quarter results, and a very weak comp in 4Q05, we generally like being owners of the shares into the December quarter, which has historically accounted for nearly 40% of NILE’s annual revenues. We continue to believe that in the current environment of slowing economic growth, rising interest rates and tighter levels of disposable income, the value proposition offered by Internet retailers like NILE has become more and more attractive to consumers.

We arrive at our $40 target valuation via a combination of P/E and EV/EBITDA frameworks. On the P/E side, we apply a 29x multiple (1.3x our long-term growth estimate of 22%) to our 2008 pro forma EPS estimate of $1.38 to arrive at $40.20. On the EV/EBITDA side, we apply a 17x multiple (0.8x our long-term growth estimate of 21%) to our 2008 EBITDA per share estimate of $2.02 to arrive $39.60.

We maintain our 2*/Above Average rating on NILE shares. Given the proximity of the shares to our target valuation, however, we recommend exploiting any sustained weakness in the shares rather than buying aggressively at current levels.

NILE 1-yr chart:

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