Blue Nile: Short Term Concerns Will Ultimately Give Way To Long Term Growth

Brian Bolan, research analyst at Jackson Securities,

Company Description
Blue Nile is a leading online retailer of high quality diamonds and fine jewelry. Blue Nile specializes in the customization of diamond jewelry with a “Build Your Own” feature that offers customers the ability to customize diamond rings, pendants and earrings. While not providing the lowest cost diamonds, the company believes its formula of no pressure sales, high quality educational material and reasonable prices will result in higher profits.

Valuation and Recommendation
The lessons of the bubble era are apparently not lost on investors of Blue Nile, but as the company grows, it could eventually create a perfect storm in terms of a ballooning valuation. At the current time, we believe that the company is one to two years away from that transformation and we initiate coverage of the company with a HOLD rating.

Introduction to Blue Nile
Founded in 1999 as RockShop.com, Blue Nile has grown from humble beginnings into the one of the largest diamond and jewelry retailers on the web. Utilizing a low inventory model, ubiquitous presence and reasonable pricing the company is poised to eventually reach a critical mass. At that point, the company can further push margins more in its favor which would improve earnings.

Engagement Ring Market
Around 72% of the sales at Blue Nile involve engagement rings, a $4.5B segment of the $57.2B overall jewelry market. Of that overall market, diamond jewelry accounts for approximately $31.5B. With total sales of $200M in 2005, Blue Nile is just beginning to scratch the surface of the total available market.

The company has stated that the average selling price [ASP] of an engagement ring is around $5,600. Even when faced with the possibility of rising commodity costs, we would expect that this number would remain relatively constant as the budget for the ring does not float up or down in relation to commodity prices. Over the last few quarters, management has noted that platinum, gold and silver have all seen fairly dramatic price increases. The company has noted that they are passing those rising costs onto consumers.

A competitor of Blue Nile, Abazias, which sells loose diamonds via the web, states their ASP for engagement rings to be $5,500. Tiffany’s (TIF) has stated their engagement ring ASP to be around $9,500. We believe that that the ASP for engagement rings to be among the most important metric for calculating sales and valuation for Blue Nile.

The company has stated in the past that 15% of its transactions have an ASP of greater than $20,000, thus Blue Nile is getting its share of the high end market. In recent conference calls, the company has highlighted the number of transactions over the $100,000 price point and has even had a sale at a $345,000 price point. We believe that this ultra-high end market, and specifically the growth within, is a key idea when assessing the value proposition of Blue Nile. As the company has stated, one of the greatest barriers they face is that of trust. As these large purchases indicate, the level of trust in not only the web model but the Blue Nile brand is growing.

Industry Outlook
The market for diamond jewelry is highly fragmented and difficult to gauge. With competitors ranging from Mom & Pop stores to Wal-Mart (WMT), getting a real sense of the industry is difficult.

The competition is wide spread and comes from companies with all different sizes. Tiffany is more in the brick and motar model which encourages users to shop at a local store after learning about the potential purchase via the web. With sales of $2.3B in 2005, Tiffany is significantly larger than Blue Nile and carries a brand value that is better than that of Blue Nile. On recent Tiffany conference calls management has noted that their sales growth is in the mid single digits, far below that of the high teens growth at Blue Nile.

Abazias is really on the other end of the spectrum. The focus of the Abazias model is loose stones. The web-based model also allows for many of the same advantages that Blue Nile has, especially that of low inventory. However, for comparison purposes, Abazias is almost too small, with annual sales of approximately $3M and a stock that is traded on a very infrequent basis. The company also recently announced a private placement of $300,000 worth of restricted stock.

A business model that more closely reflects that of Blue Nile would be that of Amazon. Amazon offers an online jewelry store that is comparable to that of Blue Nile. Its trusted brand name and millions of customers also give Amazon.com a leg up in the ‘trust factor’. Due to the overall size of Amazon, the company does not break out sales of its jewelry store versus its other lines, making it somewhat difficult to estimate what portion of the $10.3B in total sales for 2006 is coming from that market.

In 2006, Amazon had 4 press releases that noted its jewelry store sales were “up more than 100 percent”. Amazon noted that in the second quarter of 2006, sales of custom built engagement rings increased 254% and its selection increased 30% to 2.6M unique items. The third quarter of 2006 saw 108% growth in the jewelry business. Clearly, all of these sales figures are coming from a very small base, so it may be some time before these growth numbers hold much merit. Until that point comes, an expectation of 100%+ from Amazon’s jewelry segment should be considered the standard for the broad based online retailer.

Management Discussion
As important as the core of the diamond market is to Blue Nile, we believe that the true value of the enterprise is online model that is managed by a talented group led by CEO Mark Vadon. Possessing deep knowledge of both the diamond industry and technology, Mark has been instrumental in leading Blue Nile to its present position.

Other key members of the management team include Diane Irvine who has served as Blue Nile's Chief Financial Officer since December 1999. Darrell Cavens has served as Blue Nile's Senior Vice President since June 2005 and his former positions include VP of Development as well as Blue Nile's Chief Technology Officer from November 2000 to June 2005.

Earnings Analysis
In looking at our estimates, we felt we would be remiss if we didn’t mention the idea of earnings growing at nearly 25% rate while net income experiences growth of about 17%. This is clearly due to the advanced share repurchase that is expected to occur throughout the year.

We wanted to highlight this as any disruption in the buyback of shares could have a dramatic effect on a potential EPS number that many valuation calculations are based on. We believe that the company will continue to repurchase shares, but are mindful that an acquisition would likely boost the share count and would be dilutive to earnings.

Share Repurchases, Short Interest and Acquisitions
Blue Nile has been fighting a war in the trenches, a war against the shorts. For some time, short sellers have viewed Blue Nile as a jewelry retailer with a “Microsoft multiple” and thus view it as overvalued. To combat this, the company has employed a strategy of continued execution on the business plan and supporting its stock through buybacks.

Short interest has moved from 14.1 to 24.2 over the past 6 months, even as shares outstanding have been reduced due to board approved buy backs. Quick analysis of the patterns utilized by the short sellers suggests that shorts may load up for another push in late March through April. We would not recommend that investors attempt to time their purchase of shares in order to enact a short squeeze.

With a fair amount of attention being focused on the war with the shorts, the company has more or less backed itself out of the acquisition market. We are not saying that presented with an opportunistic acquisition the company will pass, but rather an acquisition might serve to dilute shares and give the shorts a rallying cry.

During the third quarter, Blue Nile repurchased approximately 239,000 shares, or about 1.5% of the shares outstanding for an aggregate purchase price of $7.8 million. Since the inception of the share repurchase program in February 2005 through the end of September 2006, Blue Nile has retired approximately 12.7% of the outstanding shares. As of the end of the third quarter, $96.4 million remains to be spent under the $150 million in stock repurchase programs that have been authorized by the board of directors.

Ad Spend
As a percentage of total revenue, the company spends roughly 4% on advertising. The company utilizes Cost-Per-Click [CPC] keywords such as diamond, engagement ring, wedding ring, wedding band and the like. The company has stated on its conference calls that CPC prices have risen dramatically and the company looks closely at the ROI’s involved. Over the last few quarters the idea of outsourcing the ad spending to a specialist firm has come up and could be a viable option for the future.

The company has refused to elaborate on its strategy to drive traffic to the site. Some talk of being a large sponsor on a portal or developing a portal has surfaced over the last year, but so have calls for more offline ads. Currently, the company believes that online advertising makes much more sense than off line ads and doesn’t want to disclose its traffic strategy for competitive reasons. We believe that in the coming quarters, the company may announce that they will be spending more to acquire more customers.

Risks
The risks involved in purchase of shares of Blue Nile include, but are not limited to: consumer demand for its products, the costs associated with procuring precious metals, wholesale diamond pricing and general economic conditions.

Along with other boilerplate style risks that most technology companies face (ability to stay current with technology platforms, drive customer to the website, retain qualified personal to maintain and operate the technical operations), Blue Nile faces some unique risks. We view Amazon’s lackluster approach to the market as risk as they may begin to increase their marketing spending in a effort to steal potential customers.

We doubt that the hundreds of independents jewelers will be able to fully organize and produce a website that would effectively compete against Blue Nile, but in the event that it did happen, it would be a viewed as a serious threat to the company.

One of the biggest risks is if Wal-Mart decides to make a major play at the higher end jewelry market. Wal-Mart’s website currently offers jewelry on the lower end of the scale, most items are priced under $1,000. Should Wal-Mart decide that they want to compete in this market, margins would likely erode.

Valuation
Like any stock, we believe the primary reason an investor should purchase shares is to capture earnings growth or earnings value. Coverage of the internet sector is synonymous with earnings growth, and a high growth rate at that. Blue Nile is clearly growing its sales and earnings at a rate higher than its diamond jewelry specific counterparts, but does it deserve the “Microsoft Multiple”?

In determining our price target, we created a multiple matrix and looked at where Blue Niles multiples landed based on our estimates for FY07 and CY06 (below). We also took at look at the margins of four competitors (above).

While TIF carries higher margins, it has lower growth. There is a very large premium being paid for NILE when compared to TIF, and this gives us some pause, but if the growth continues as expected and margins eventually improve, we believe that buying shares of NILE would be advisable. Currently that is not that the case and we recommend that investors HOLD shares of Blue Nile.

Thesis
Blue Nile is an excellent example of the idea of what an e-commerce based company should be. Its meager beginnings and accession to a leading position in the market underscores the effectiveness of the Internet model. While the current competitive environment and commodity price fluctuations have caused concern, we believe that over the long term, the company will reach a critical mass and be able to increase margins to the benefit of shareholders.

Earnings Model for Blue Nile
click to enlarge

NILE 1-yr chart: