Blue Nile: The Tiffany Of The Internet?

| About: Blue Nile, (NILE)

Summary

Blue Nile boasts a strong position in engagement rings with longstanding supply relationships, high-end brand positioning, and a low cost structure relative to brick-and-mortar peers.

Blue Nile generates but a slice of revenue as operating income, and costs to build trust for buying diamonds and fine jewelry online will be ongoing.

The US jewelry market has shown decent growth during the past 30 years, with a compound annual growth rate of 4%, despite recessionary declines.

Let's take a look at the firm's investment highlights as we walk through the valuation process and derive a fair value estimate for shares.

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By The Valuentum Team

Blue Nile (NASDAQ:NILE) is a leading online retailer of high-quality diamonds and fine jewelry. The firm offers products for sale through the Blue Nile website in dozens of countries and territories throughout the world. The firm reported diluted net income per share growth above 12% in 2015 thanks in part to growth initiatives in its three main categories (US engagement, US non-engagement, International). As a result, Blue Nile paid its first ever dividend in March 2016.

Because of Blue Nile's virtual inventory model (virtual inventory includes not only the products the company has on hand, but also products it can obtain from suppliers and sell to customers) for loose diamonds, its diamond product prices are much more sensitive to fluctuations in the prices of diamonds than traditional retailers, which commonly hold diamonds in inventory. Rapid and significant fluctuations in commodity prices, particularly diamond prices, may materially and adversely affect its sales, gross margins, and competitive position. Investors have to watch such a dynamic closely.

Blue Nile's business model, however, enables the firm to pursue a dynamic merchandising strategy. The company's fundamentally more efficient overhead and centralized inventory enables it to operate on low margins. The use of the virtual inventory also enables the company to 'carry' a more diverse product mix than it otherwise would, thus allowing it to attract a wider range of potential customers. Does all Blue Nile have to do now is build a brand that stands for quality like the 'blue box' at Tiffany (NYSE:TIF)? Will Blue Nile become the 'Tiffany of the Internet,' as consumers become more and more comfortable shopping online? It's exciting to think about.

Blue Nile's Investment Considerations

Investment Highlights

  • Blue Nile is the leading online retailer of diamonds and fine jewelry. The company boasts a strong position in engagement rings with longstanding supply relationships, high-end brand positioning, and a low cost structure relative to brick-and-mortar peers. It was founded in 1999 and is headquartered in Seattle, Washington.
  • Blue Nile is a rather small operation given its brand awareness, in our view. The company only generates but a slice of revenue as operating income, and costs to build trust for buying diamonds and fine jewelry online will be ongoing.
  • Shopping online has become a way of life for many Americans, but a little blue box from Tiffany's always seems to find a way to delight the recipient. Competition will remain intense, and even the highest quality standards at Blue Nile may not sway the marginal consumer from a highly-recognized, competing branded source.
  • The US jewelry market has shown decent growth during the past 30 years, with a compound annual growth rate of 4%, despite recessionary declines. Blue Nile will continue to benefit from this pace of expansion.
  • The US jewelry industry is also very fragmented, with the top 20 retailers making up just less than 30% of the market segment. This presents an opportunity for Blue Nile to make market share gains.

Business Quality

Economic Profit Analysis

In our view, the best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital with its weighted average cost of capital.

The gap or difference between ROIC and WACC is called the firm's economic profit spread. Blue Nile's 3-year historical return on invested capital (without goodwill) is 21.7%, which is above the estimate of its cost of capital of 10.8%. As such, we assign the firm a ValueCreation™ rating of EXCELLENT.

The concept of an economic moat - or sustainable competitive advantages - focuses purely on the sustainability and the duration of the competitive advantages that a firm possesses. The concept of an economic moat does not consider the cumulative sum of a firm's potential future economic profit creation, but only that at some point in time in the future, a moaty company will continue to have an economic profit spread and a no-moat firm will not.

Let's examine the problem that arises by focusing exclusively on companies that have economic moats, or sustainable and durable competitive advantages.

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Image Source: Valuentum; EVA is trademarked by Stern Stewart & Co

In the chart below, we show the probable path of Blue Nile's ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.

Cash Flow Analysis

Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Blue Nile's free cash flow margin has averaged about 2.6% during the past 3 years. As such, we think the firm's cash flow generation is relatively MEDIUM.

The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. At Blue Nile, cash flow from operations decreased about 66% from levels registered two years ago, while capital expenditures fell about 32% over the same time period.

In the first quarter of 2016, Blue Nile reported cash used in operations of ~$47 million and capital expenditures of ~$1 million, resulting in free cash flow generation of approximately negative $48 million. This is a slight improvement over roughly negative $51 million in free cash flow in the first quarter of 2015.

Valuation Analysis

This is the most important portion of our analysis. Below we outline our valuation assumptions and derive a fair value estimate for shares.

Our discounted cash flow model indicates that Blue Nile's shares are worth between $24-$36 each. Shares are currently trading at ~$26, in the lower half of our fair value range. This indicates that we feel there is more upside potential than downside risk associated with shares at the moment.

Our expectations for revenue and earnings in 2016 and 2017 are similar to consensus estimates. Revenue and earnings are both projected to be roughly flat in 2016 compared to 2015 before returning to modest growth in 2017. We're anticipating stronger growth in coming years as the traditional model of retail should continue to be challenged. As an online retailer holding virtual inventory, Blue Nile's business is not very capital intensive.

The margin of safety around our fair value estimate is derived from the historical volatility of key valuation drivers. The estimated fair value of $30 per share represents a price-to-earnings (P/E) ratio of about 33.5 times last year's earnings and an implied EV/EBITDA multiple of about 13.6 times last year's EBITDA.

Our model reflects a compound annual revenue growth rate of 3.5% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 6.3%. Our model reflects a 5-year projected average operating margin of 3.9%, which is above Blue Nile's trailing 3-year average.

Beyond year 5, we assume free cash flow will grow at an annual rate of 1.5% for the next 15 years and 3% in perpetuity. For Blue Nile, we use a 10.8% weighted average cost of capital to discount future free cash flows.

Margin of Safety Analysis

Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $30 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values.

Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph above, we show this probable range of fair values for Blue Nile. We think the firm is attractive below $24 per share (the green line), but quite expensive above $36 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.

Future Path of Fair Value

We estimate Blue Nile's fair value at this point in time to be about $30 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart above compares the firm's current share price with the path of Blue Nile's expected equity value per share over the next three years, assuming our long-term projections prove accurate.

The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change.

The expected fair value of $41 per share in Year 3 represents our existing fair value per share of $30 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.

This article or report and any links within are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions, and estimates are based on our judgment as of the date of the article and are subject to change without notice.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.