Wow. The last thing I expected when I wrote a short article on Blue Nile (NASDAQ:NILE) was a vigorous, aggressive response from people who don't (they say) hold any shares of this nice little stock. Wow... This article is a short response explaining some fundamentals of business, e-commerce, and technology, using the criticisms as a vehicle.
My short thesis is this simple: As a discount retailer than happens to sell online, a P/E of 40x is too high. Google (NASDAQ:GOOG) at approximately 30x gives us a ceiling on the valuation, while Wal-Mart (NYSE:WMT) at 15x gives us a floor.
The responsive thesis is, basically, "that isn't how e-commerce works" or "what about the value of the website, they'll corner the market!"
Analyzing that question -- how should we value NILE's "website" -- is the subject of this article.
What's a Website and How Do We Value It
Somewhere, people got the idea that a "website" is, alone, a thing with value corresponding to its rate of growth in "hits." This is an old idea from the 1990s that, numerous Internet stock crashes in, really should be gone by now.
Let's take a "website," like Facebook (NASDAQ:FB) and figure out what someone would be buying if they bought Facebook.
First, there's the data. A decade's worth of "likes," e-mails, photos, wall content, etc., all there for advertisers to mine. That's value.
Second, there's the network externalities. A network externality occurs when a thing becomes more valuable when (simplifying) more people use it. Let's say we invented a better social networking site tomorrow. Even if a few people switched, that would happen slowly, because people want to communicate with their friends and their friends are already on FB. A network externality does two things: It increases the value of a business by increasing the value the business' service offers to users, and it creates a larger barrier to entry for new competitors.
Third, there's the "idea," the "concept" of FB. That's clearly worthless. We know this because FB didn't have the idea for FB, and didn't pay the people who did. Before FB there was Myspace, and before Myspace there was Friendster. Maybe someone had the idea before Friendster, but Friendster was certainly years ahead of FB. They had the "concept." But Friendster failed, which brings me to the next thing FB has to sell.
Fourth, scalable technology and infrastructure. Building a web interface is easy (that's going to be fifth, below). Building a web product that can handle massive amounts of data for tens of millions of users simultaneously and deliver that data quickly around the world, now that's hard. If you look at the capex and pp&e for a thriving web business like FB or GOOG, you'll see that the money isn't going to building a web interface. It's going to servers, networking, data storage, and building the technology required to link all of that together.
This issue, scalability, is why Oracle (NYSE:ORCL) makes so much money. Their product is a scalable database. If you're building a commerce website or just running logistics for a supply chain, Oracle's database products can handle large amounts of data to lots of users simultaneously. It won't crash when you get bigger.
But it doesn't get an FB or a GOOG where they need to go. FB and GOOG have data quantity, data serving, and data processing needs beyond what a general-purpose solution like Oracle's products can provide. So FB and GOOG have to do it themselves. Part of each company's business is running a kind of mini-Oracle making their own custom database. In fact that's a *lot* of their business. Plus the server farms, the electricity, the networking...
Fifth, there's the web-interface technology. This is what people see when they log in, so they think that's where the capex is going. Not true. (Well, a lot of capex goes to figuring out what to do with the *next* interface and the *next* product, but that's different.) Making a website, in the sense of a functional web interface that can handle a few users at once, is very, very, cheap.
One expert estimated that FB's website could be duplicated with $500,000 in nine months. Twitter, 10 hours of work.
Duplicating Google would be a lot harder, because (A) GOOG has a lot of different web products now, (B) they talk to each other, and (C) GOOG's core search technology is the result of an original (patentable) innovation in computer science plus more than a decade of refinements and work.
But making a web interface itself, that's easy.
And that leaves six, the domain name. Allow me to suggest that if facebook.com was called instead "weirdfunnyname.com," it wouldn't be less successful. "google.com" could be "bobssearchengine.com" or anything else. The name just doesn't matter.
There is such a thing as brand value, which is the association in a consumer's mind of quality with a particular vendor. People seem to think brand value is very large. Well, the movement from Myspace to Facebook didn't take very long; Circuit City, with more than $10bn in annual sales, sold its marks and domain name for $6.5mn.
In a famous old article on goodwill (which I can't locate online), Buffett said that goodwill as an asset is the fact that people will continue to return to a supplier again and again, meaning that the company's cost to generate cash is lower. And the P/E multiple, as we all know, is the market's estimate of the value of a company's goodwill.
Allow me to suggest that what makes businesses like Google and Facebook successful isn't their names, and it isn't advertising (do they advertise much?) and it isn't brand value at all --- it's the extraordinary amount of work that these companies' founders and employees put in over a decade of time to build quality products, find new ways to expand their businesses, keep the products running fast as the userbase grew, prevent outages, etc. etc. It's the capex.
I don't think companies like FB or GOOG actually have lots of goodwill. In fact, I don't think they have much at all. I think people would move from GOOG to a new search engine in six months if someone built one; moving from Gmail would take longer, but not so long. And the same for FB -- moving from Myspace didn't take very long, and data is easily exported from FB and could be easily imported to a new service. If these companies had lots of goodwill, they wouldn't have to spend such a large portion of their revenue on capex. High capex means low goodwill. It means the company has to keep spending money to stay ahead of competitors and keep generating revenues. It implies a low multiple.
So I don't think the "bluenile.com" domain name or "Blue Nile" trademark are worth very much.
Pricing Blue Nile
So back to Blue Nile. Blue Nile is a well-run company growing at 10-15% a year. It is a discount retailer that aims for high volume with low gross margins. It displaces the kind of high-margin retail business where you walk in and a commissioned sales person takes advantage of what you don't know, the difficulty of comparing prices, and your immediate presence to push a sale.
Blue Nile's website is not complex. If Facebook's interface could be duplicated for $500,000 in nine months, do we really think Blue Nile would require more? Of course not. As for the back-end, servers and such, hard numbers are hard to find, but I'm going to guesstimate that Blue Nile's data and networking usage is sub-atomic compared to FB's or GOOG's.
Blue Nile does not have network externalities. The fact that my neighbor bought on Blue Nile, does not mean that I get more value buying from there than I would from a competitor.
Blue Nile does not have other strong barriers to entry. There is a vigorous diamond and jewelry wholesale market, Blue Nile hasn't locked-up any of those dealers and can't do so; and a number of companies both retail and online have existing jewelry fulfillment infrastructures.
Blue Nile does not collect or have much user data. People don't use it for e-mail or to store photos.
Blue Nile does not have discernible brand value. There isn't a lot of return business for engagement rings. People could switch from Blue Nile to a better vendor in a microsecond the same way they decide to buy a flight from Delta instead of United.
"Cornering The Market"
That leaves one part of the long thesis, which is that Blue Nile will grow and grow until it dominates its market.
Existing brick-and-mortar retail competitors have not chosen to enter Blue Nile's market space, even when they've gone online. Even the jewelry part of Amazon's (NASDAQ:AMZN) website is weak -- Amazon isn't spending money to try to tap that market.
Now, none of us really think this is because Tiffany's (NYSE:TIF) or Amazon think that they'd lose if they tried to compete head-to-head with teensy Blue Nile on technology, fulfillment, or marketing. So the fact that these companies aren't going after Blue Nile's niche tells us that they don't believe the niche is very big.
But suppose Blue Nile did corner the market. If the company was able to show growing gross margins, then low barriers to entry would bring in new competitors in days.
I got involved with SeekingAlpha only recently, so you won't see the record of it, but I used precisely the logic above -- high capex means low goodwill means low multiple -- to price FB around its IPO and for the few months that followed (after which I stopped paying attention). I called the price to within 10%.
Buying the Company
But, people ask, why won't some other company come along and buy it? Well, they may. The question is what they'd be willing to pay for it. A TIF or other existing near-direct competitor will already have its own fulfillment network and back-end, so they would be paying to save the cost of developing their own website, and to get rid of one of many online lower-cost competitors. That's all NILE has to sell TIF.
Generally people won't pay more to buy a business than it would cost them to replicate that business. I don't think it would cost $420mn to replicate Blue Nile's business.
Blue Nile is not a "web business" in the sense of Twitter, Facebook, Instagram, Google, Netscape (remember that one?) or the like. It is an online discount specialty retailer along the lines of adorama.com, leisurepro.com, and the like. There's nothing wrong with that, and Blue Nile is a well-run, growing business with a quality website that seems to be satisfying its customers well. But it is not Google.
GOOG is a seasoned company with a decade of expanding into new business areas. Its consistent 20+% yoy net sales growth is nearly double NILE's. It trades at 30x trailing P/E and 20x forward P/E.
NILE is a comparatively new company with a few years of experience, a single product line, no aim to branch into new products (and there's no natural direction for it to move).
So I don't see a rational justification for NILE to trade at a higher multiple than GOOG. NILE is not diversified or seasoned. Growth wouldn't justify a multiplier higher than GOOG's because GOOG is growing more quickly. I use GOOG as a ceiling.
TIF generates yoy net sales growth of around 7%, and trades at a trailing P/E of 25x and forward P/E of 20x. Let's use that as our base case.
For our worst-case, I'm going to pick WMT, because the gross margins are similar. Trailing P/E is 14.6x, forward P/E is 13.7x. So that's our floor. But, NILE's beta is much higher WMT's, and NILE deserves a higher multiple for that reason.
I therefore say NILE's trailing P/E would be reasonable at 25x, and maybe on the high side at GOOG's 30x. Right now NILE trades at approximately 40x trailing P/E and 30xforward P/E.
Indeed, the company's stock price has dropped each time it's released quarterly earnings.
I have yet to hear any rational justification for why NILE's multiple should be so out of line with its comparable.
Nothing in here should be taken to imply that I don't like NILE as a company or like its long-term prospects. Quite the opposite, in fact, as I discussed at length in the prior article.
I think NILE's a good company, for a new company it's great. I just think the multiple is too high.
Finally, a Brief Note on Amazon
Before someone says it, yes, much of the logic here would apply to AMZN. Just because AMZN has a P/E of 605x doesn't mean NILE should. Or that AMZN should.
AMZN has an extraordinary distribution and fulfillment network, but that alone hardly justifies the extra-galactic multiple.
The theory underlying AMZN's valuation (to the extent I've been able to find any rational explanation) is that at some point AMZN starts to charge a little more and then its meager earnings skyrocket because of its volume. But let's be honest, unless we're looking for books or DVDs, we end up on Amazon's site after Googling for the product we're looking for. If someone else sold it for cheaper we'd buy from them.
I don't think AMZN's multiple can be defended on any valuation theory. I don't think it's rational. I think it's a combination of herd-buyers ("it's going up let's invest") and event-driven traders who give it a nice pop each time it releases earnings. And the stock is too large and too volatile for shorts, so irrational pricing prevails.
At some point, I think, either AMZN's price drops drastically, or the price fails to grow over an extended period of time until it catches up with earnings. But I have no idea what would trigger either of those things, and I don't touch the stock for that reason.
NILE could turn into another AMZN, valuation-wise. But when you see something in the distance shaped like a horse, you're better off assuming it's a horse than a zebra.
Either way, AMZN is hardly a basis for valuing NILE.
Additional disclosure: If the price of NILE derivatives changes substantially, I might take a position.