Blue Nile: A Classic Underpromise, Overdeliver Company

In preparation for this article on Blue Nile, Inc. (NILE), you might wish to review some of my prior articles:

• Impressive First Quarter For Blue Nile;
• Not Paying Attention To The Blue Nile Bears;
• Blue Nile Bull And Bear Square Off; and
• Citigroup Upgrades Blue Nile; and
• Outstanding Second Quarter 2007 For Blue Nile.

To set the stage, I used Yahoo's financial website to pick up the analysts' estimates prior to the conference call.

Blue Nile: Revenue and Earnings Estimates

Financial Metric	Current Qtr Sep-07	Next Qtr Dec-07	Current Year Dec-07	Next Year Dec-08
Data Sources	Yahoo Finance 5 November 2007
Revenue Estimates	68.02M	114.08M	321.75M	389.64M
Earnings Estimates	0.16	0.44	1.02	1.29

I updated the table below to reflect actual values and company forward guidance.

Revised Blue Nile: Revenue and Earnings Estimates

Financial Metric	Current Qtr Sep-07	Next Qtr Dec-07	Current Year Dec-07
Data Sources	Company press release and conference call transcript
Revenue Estimates	67.4M	109M – 115M	316M – 322M
Earnings Estimates	0.18	0.40 – 0.45	1.00 – 1.05

As you review and compare the information above to my prior articles, you will note that guidance has gone up, again. Blue Nile is a classic underpromise, overdeliver company.

This most recent quarter's results are strong, indicative of a well managed and growing company. To be honest, with the housing and energy issues, I was unsure of the company's performance this quarter. The company's performance, however, indicates that it is doing well.

From the company's conference call transcript (courtesy of Seeking Alpha):

Analyst for Imran Khan - JP Morgan

A quick question just about holiday sales. Are you expecting non-engagement sales to trend, given the tightening economy? Have you seen any changes in competition domestically from people such as Amazon (AMZN) for the holiday season?

Diane Irvine

In terms of holiday trend, I think as we had mentioned in our comments earlier, as we have started the quarter we're seeing very strong momentum so that is great. I think in terms of consumer spending or what you see more broadly, I think we have always said we don't exactly know. I think there's a very strong argument that when you look at engagement, that is less discretionary. I can only point to what we're seeing, which is great strength in the business, even stronger at the beginning of Q4 I'd say than what we saw in Q3. Of course we are taking share, so I think we're a bit different than you see in retail broadly. But I think we feel very optimistic today in that we're well positioned for the holiday season.

In terms of competition, I would really just point to what Mark talked about earlier, that I feel every quarter we get ahead of the competition and really expand our lead. Mark mentioned our international business as being larger than any of the US competitors in terms of engagement online. I think we need to continue to get better and better at what we're doing, which is why we focus so heavily on the customer experience. I think you see that happening.

Similar to my prior article on Blue Nile's last quarter, rather than parsing through the conference call in detail, I am going to provide some quick snippets to give you a sense of how the company is performing.

• Net sales of $67.4 million, an increase of 26.5% over the third quarter of 2006;
• Gross profit grew by 28.4% to $13.4 million, and operating income grew by 67.3% to $3.6 million;
• Net income of $3.0 million and net income of $0.18 per share, representing an EPS growth of 63.6% over the same period last year;
• In Q3, total orders increased 16.3% as compared to a year ago.
• Average selling price per order was $2,093 in the third quarter, up 11% to $1,884 from the same period last year;
• Website traffic growth strong, stronger than it has been during the last couple of years; and
• Sales and merchandise priced above $25,000 grew by over 50%.

Similar to the last quarter's earnings release and conference call, I did not find anything any weaknesses or causes for concern. The company is performing extraordinarily well and is getting bigger and stronger with time. The key consideration is valuation, of course. Let us look at some quick numbers.

Blue Nile: Key Financial Metrics

Financial Metric	NILE
Data Sources	Yahoo Finance, 7 November 2007 & Company Press Release
Market Cap.	$1.28B
Enterprise Value	$1.12B
Forward P/E (fye 31-Dec-08)	62.7
PEG Ratio (5 yr expected)	3.21
Enterprise Value/EBITDA (ttm)	53.978
Qtrly Revenue Growth (yoy)	26.7%

The values quoted above will be modified once the company's latest results are incorporated. You should keep in mind that in two to three months the forward P/E will be based upon 2009 earnings, not 2008. If we assume 25% growth in earnings for 2008 and 2009, then 2009 earnings will be about $1.60 per share. With the current price of about $80 per share, Blue Nile has about 50 multiple on forward earnings for a company that is growing at 25%. Because the company is still in the early phases of its growth, I think the valuation is very reasonable.

Note that my 25% growth value was arbitrary. The company exceeds 25% growth for many of its metrics. I chose 25% because it was a convenient number that was near the net sales growth this quarter. My guess is that the actual growth rate will be higher.

Blue Nile indicated that it is taking share away from other jewelry retailers. As mentioned in my prior Blue Nile earnings, I believe we are witnessing a transfer of value from the traditional retailers to Blue Nile and its customers. Thus, I am not fussed about the current forward P/E ratio because one, Blue Nile is performing exceedingly well operationally and two, Blue Nile is still a relatively young and relatively small company with plenty of potential growth ahead of it.

According to Yahoo and Short Squeeze, there are about 3.36 million shares short, which with a float of 11.25 million shares, means that about 22% – 30% of the shares outstanding are short. That translates into a short interest ratio of about 5 to 8 days. Remember, the short interest ratio is the number of days of average trading to equal the total outstanding short position. Both providers indicate that the number of shares short increased from the prior month's value of 3.46 million shares. While both providers' values are reasonably close to one another in our situation, I find it helpful to check both.

I continue to be an enthusiastic supporter of Blue Nile. Wednesday the S&P is down 1.88% to 1491.72, while NILE is up 9.31% to $81.63. Prior to the second quarter (not third), the price was near $83. The stock price has been volatile during the recent quarter with the price having reached slightly over $100 and falling back to low $70s before bouncing back Wednesday to the low $80s.

As stated in my first quarter summary, I do not have a target price for Blue Nile. I continue to monitor the stock. I believe the company is well managed and poised for even greater success. For those that are interested in investing in Blue Nile, I highly encourage you to read the conference call transcript to form your own independent assessment. My enthusiasm for the company and its stock are not a recommendation. You must perform you own independent analysis and make your own independent decisions.

Disclosure: I am long Blue Nile stock, short calls, for a net long position. Please note, I maintain a core long stock position and trade around Blue Nile using both stock and options.

Update

The market closed down Wednesday. The Dow fell 360.92 to 13,300.02, a loss of 2.64%; S&P fell 44.65 to 1,475.62, a loss of 2.94%; and Nasdaq fell 76.42 to 2,748.76, a loss of 2.70%. Blue Nile stock closed up $6.83 to $81.51, a gain of 9.15%.

Comments

[rock boy:]

Interesting comments. I think you missed one small item - orders only grew 14% in the quarter y/y. Avg Selling Price (ASP) increased 11% in the quarter (and Gross Profit per order followed suit) not due to price increases but simply due to mix. The last time the company posted a double digit ASP increase was Q2 06 - 13.6%. The next quarter it was 6.3%, the quarter after that it was 2.3%. So assume that ASP growth will revert to the mean (it has averaged 5% over the last 8 quarters) and order growth remains mid teens, you have revenue growth of ~20%. Not too shabby. Assuming they earn the $1.00 they are guiding to this year and can get operating leverage they can grow earnings 30% next year (on 20% revenue growth), they'll do $1.30 next year. Also not too shabby. But you have a stock that is trading at (hope you are sitting down) 63x that 2008 number.

When they asked the CEO about the slowing order growth his response was he doesn't even think about orders just traffic. I don't think I've heard a CEO of a public Internet company utter those words since February 2000.

Net net, good company? Yes. Very good business model? Yes. Worth 63x next year's earnings? Not a chance.

2007 Nov 08 09:18 AM

[Stecyk:]

Hi Rob,

Thank you for your comment.

I don't disagree with your 63x times 2008 earnings or about 50 times 2009 earnings, which was referenced in the article. If the company can continue to grow earnings at 25% at year for the next few years, then I have no concerns.

Again, they are taking share away from other jewelry retailers. They have no significant online competition. So my view is that the brick and mortar retailers will continue to decline in value and some of that value will go to Blue Nile. Most of the value, however, will go to consumers.

It will be interesting to watch how the company performs over the next several quarters.

Best regards,
Kevin

2007 Nov 08 10:38 AM

[coitus:]

but if they are really taking so much share then why are orders only growing 15%? Wouldn't they be growing far faster given what a small piece of the overall pie NILE represents?

My other point is this, if the company can grow earnings 25% per year, what multiple do you assume the company will trade on 2010 earnings? Assuming they earn $1.05 in '07 and grow 25% per year then 2010 earnings will be $2.05. Let's assume they slow down to 20% growth after that. At a 1.5x PEG, the mutliple would be 30x. 30x $2.05 in earnings, you have a $61 stock. Congratulations, you've managed to lose $20 per share off of today's close over the next 3 years. To justify this multiple, you need to have hyper growth - 15% growth in orders isn't hyper growth.

2007 Nov 08 08:18 PM

[Stecyk:]

Thank you coitus for your comment.

I am short ZLC and long NILE and have been since late March. You can check my posts on both stocks. I've done extraordinarily well with my paired trade. Thank you for your congratulations.

As for the future, let's wait and see. Something for you to consider is that Canada's economy is extremely strong economy and the U.K.'s economy is strong too. Do you think it is conceivable that the leading online jewelry retailer in all three countries could be worth $2-5 billion in five years? If so, I'll let you do the math on the share price.

2007 Nov 08 08:34 PM

[coitus:]

You deserve congratulations for owning the stock from $35 to $60 - beyond that you've been lucky and I think you'll be biding time. "Being the leading online jewelry retailer" has no implicit value unless the business model and profitability justifies the valuation. You've been right about your ZLC trade but keep in mind that the "leading retailer of jewerly in the US and Canada" also known as Zales has a market cap of $965 mm - that math doesn't seem to support your $2-5 bn market value for NILE.

2007 Nov 11 02:50 PM

[Stecyk:]

You're right, ZLC has only $965M market cap today. It was much larger back in March. And nearly double that amount in July 2006.

With regard to my $2-5 billion, while it is true that Zales value alone won't provide all the value, other jewelry retailers might. According to ZLC's last 10K (July 31), their revenue was $2.4 billion. That would seem to imply, at least to me, that jewelry is a highly fragmented market. So an effective online retail jewelry might sell that amount and much more in a short period. And remember, NILE is serving Europe too, not just North America.

I can almost see your reply now suggesting that the NILE's growth rates don't seem to support that assertion. After all, NILE, a small upstart, already has anticipated annual revenues of $320 million. My reply is that we are still in the early innings. We really don't know how well internet commerce will play out. I remain confident, however, that NILE's best days are ahead.

I recall when traditional bookstores were plentiful. I still remember going to specialty bookstores for specialty books. Now, I just use Amazon and my prior bookstores have disappeared. Poof, gone.

Will that happen to jewelry retailers? I don't think it will to the same extent. But I do think traditional retailers will need to adapt in order to survive.

I remain bullish and you remain bearish on NILE. That's what makes markets, no?

2007 Nov 11 03:57 PM

[borisb:]

It looks like the UK and CANADA online divisions were about 7% of total revenue and growing at a rate of 100% year over year in the 3rd quarter. If the growth in the UK and CANADA remains robust like this next year.... they would add about 7% to the top line growth rate. In the US business grows around 20%+ and the international adds 7%, then next year the top line is 27%+. in the 2009 the international growth might add about 10%+ to the top line if this division(s) grows around 50%.

2007 Nov 13 08:07 PM

[borisb:]

and it appears they have cornered the market. others have tried and failed, amazon.com isnt in the same space, and nile widens the lead with each passing quarter. notice the situation..."Everythin... is trending in the right direction," said Dan Geiman, an analyst with Seattle-based McAdams Wright Ragen. "There is no competition out there. ... Others have tried and failed, and no one is out there in their segment of the market to make any noise. Blue Nile has captured the market."

2007 Nov 13 08:19 PM

[BlueGalt:]

Though I have bought and sold NILE I ran across this article while browsing the site and found your analysis both detailed and well-thought out. I watched NILE's price action last spring as the fundamentals were solid and the price action was in a long base pattern. I bought it as it was passing up thru the $40 range, held on during the decline this Aug., but then finally sold it when the DOW couldn't hold about 14,000 and NILE began to decline again.

The company made me just over 130% and I hope to participate in its next advance.

Great work.

2007 Nov 15 08:37 AM

[borisb:]

what next advance?

2007 Nov 17 06:56 PM

[borisb:]

THINKEQUITY says International may grow at a 60% to 80% annual rate for next 3 years and reach 13%+ of total revenue vs. under 7% today. that would be a terrific long term catalyst!

2007 Nov 18 08:30 PM