I'm a credit guy, not an equity guy. Two days ago I'd never heard of Blue Nile (NILE) (I'm not the marrying type). But I read a long-thesis from an investor for whom I have an extraordinary amount of respect, I took a look at the company, and I like it. As a short.
My short thesis does not have the depth of quantititve analysis I put behind my credit theses, so don't expect that from this article. My short thesis is simple: The long thesis is wrong, once the error is corrected its apparent that the stock trades at far too high a multiple, and a back-of-the-envelope rough estimate of fair value is a share price of $21 ($17 bear, $25 bull) rather than the current $33.7.
Background and Business Model
Again unlike the companies I usually look at, Blue Nile is a well-run company with a well-thought-out business plan that is generating a profit and should grow in the long term. After so much time in the distressed-debt world, looking at the reports of a profitable equity with a good business is freaky-deaky. (This is a technical term.)
Blue Nile's business is selling jewelery online, particularly (about 2/3 of net sales according to its most recent filings) engagement rings. The macro-trend is the same one by which 47th St. Photo replaced the neighborhood photography store in the 80s; Adorama, B&H, and a gajillion clones replaced 47th St. in the late 80s and early 90s; and e-bay (EBAY) displaced them all: The sale of complex goods, where the customer is at a severe informational disadvantage, moved from face-to-face high-margin deals with commissioned sales people to lower-cost mass retailers that drastically out-compete on price.
Beyond price, as a man, if I was shopping for an engagement ring without my fiance present, I have to say I'd feel a lot more comfortable doing it online, over the web, in the evening, than taking a week off work to sit in one jewelry shop after another trying (and most likely failing) to get something she likes without getting ripped-off. So I find Blue Nile's business very appealing.
Blue Nile's margin of income before taxes to net sales is about 3%. This is an unusual metric to use, but I think its the right one here. EBITDA is a poor metric for Blue Nile because almost all of the company's capex goes to software development. Blue Nile has to spend that every year so its better treated as an expense (their reporting is consistent with GAAP, as far as I can tell). Since the amount is stable, D&A isn't far off the adjustment we'd make to CAPEX, so EBIT can proxy adjusted-EBITDA. And since Blue Nile has very little debt, interest expense is minimal, pre-tax income is a nice rough proxy of EBIT. The circle is closed.
Blue Nile is also an efficient operation with respect-worthy corporate governance. It runs with very little working capital by (where it can) purchasing product after an order is placed rather than sitting on inventory. In fact working capital was negative recently, but that was because of a share buy-back, and if you take that out it was around $6mn against est. $440mn in annual sales. That's far more efficient than your local jeweler. Moreover, recognizing that its business model scales well and there are few opportunities for acquisitions, the company acknowledges that shareholders would obtain a higher ROE investing the company's profits elsewhere by declining to take on debt and maintaining a consistent rate of stock buy-backs with its profits.
The website is also pretty good, I spent a few hours playing around on it. So, a solid business, on the right side of macro trends, well-managed, and the managers respect the shareholders. From what I know, I like the company, I think it will have a good long-term life, and I hope it does.
Oh - management is fairly compensated and incentivized with stock, and the reporting is detailed and helpful. They don't seem to want to hide anything. Again, nice...
Yet I think the stock is a short. The reason is P/E.
Ratios and the Long Thesis
Blue Nile trades, as of this writing, at a P/E ratio of about 38-40x. Not Amazon (AMZN) astronomic, but certainly stratospheric. Retailers with low margins that are in steady-state growth trade at a P/E of about 15x. Wal-Mart (WMT) (quite comparable in terms of margins, although not in any other way) is an example.
The long thesis for Blue Nile is that we should value it like an Amazon, as a company that will dominate its market. That's the wise-man's mistake. This isn't 1996 and Blue Nile isn't Amazon. Blue Nile has lots and lots of competition. Google for online engagement-ring and diamond sellers and you'll see a slew of them. Barriers to entry are also very low. Blue Nile hasn't (can't) lock-up its suppliers, and diamonds are a commodity. Indeed, Blue Nile's business works because it takes something that sold wholesale at commodity prices and retail at bespoke prices and sells it low-margin high-volume like the commodity it is. It would not be hard for an existing jewelry chain or store to get into the market; all they have to do is pick a different name so they don't cannibalize retail store sales, spend a few million to build a website, and boom.
So let's cut to the valuation.
Net sales have been trending upwards at ~15%/yoy, net income at ~13%. At that rate of growth, Blue Nile's earnings will justify its market capitalization -- in the sense that P/E will drop to the 15x typical of low-margin, efficient, well-run retailers -- in 2022.
That is -- I proudly admit -- a back-of-the-envelope calculation. I haven't taken into account dividend reinvestment, restricted stock, employee incentive plans, and so forth. Nor have I said what multiple I think the company should trade at, or given a 12-month (or 2-day) price target. I've only concluded that its overvalued today. Industry multiples expand and contract with equity risk premiums, and I'm not a macroeconomist.
Keeping things simple, very back-of-the-envelope, being generous to the company in light of its consistent growth, efficiency, and management performance, I think a base case of 25x, with 20x bear and 30x bull, is fair. That translates to a share price of $17 to $25.5, with $21.25 as the base. What triggers the move is hard to say, especially since this is a small-cap stock with (presumably) not many owners. So if I was to take a short position, I'd probably do it using long-dated derivatives.
But hey, that's just me.
Additional disclosure: I have no plans to take a position, directly or indirectly,in the next 72 hours. If I see a well-priced derivative, or the stock drops to what I think is a more reasonable price, I might well go for it though. Oh - and just because I've expressed a view here, even if I'm right about the investment, that doesn't mean the investment is necessarily right for *you*. What's a suitable risk for you and your portfolio is between you and your financial advisers. Especially with a smaller-cap thinly-trade stock like NILE, you should research the company thoroughly before making an investment decision.