Positive Intra-quarter Updates Keep Blue Nile Attractive (NILE)

Includes: NILE, TIF
by: Mark Mahaney

Mark Mahaney Smith Barney CitigroupCitigroup analyst Mark Mahaney updated his long thesis for Blue Nile (NASDAQ:NILE) in a recent note to clients:

We continue to recommend buying NILE at these price levels. Our positive bias to the shares hasn’t changed since March quarter earnings. In terms of intra-quarter datapoints, we would highlight the following:

1. Diamond search keyword prices are showing some stabilization signs –We track approximately 20 diamond- and jewelry-related keyword prices in order to gauge the marketing environment for NILE. By way of background, one of the main factors behind NILE’s disappointing December quarter results was a spike in online search pricing. In the face of 50%-80% spikes in keyword pricing, NILE cut back its online search budget and accordingly lost leads and missed its revenue guidance.

Our June quarter tracking indicates that keyword prices have stabilized somewhat. Specifically, back in March the average winning keyword bid for the terms we track was around $1.70, with a maximum bid of $6.83 for two of the 20 terms. Now it’s down to under $1 on average, with a max bid of just $1.50 for 2 terms. So lower prices + less variability (standard deviation went from the $1.80 range to ~$0.41).

The caveat here is that diamond- and jewelry-related keyword pricing is highly seasonal with lots of volatility. The key season is the December quarter, which has historically accounted for 36-38% of NILE’s annual revenue. While June quarter trends are not indicative of annual trends, at the margin we see the recent stabilization signs as a positive for NILE.

2. Competitor Odimo pulls out of the online diamond market – Odimo was one of the few remaining Internet jewelry pure-plays, and its www.diamond.com website was consistently in the Top 10 forWeb traffic according to comScore (it was 7th in Q1:06). Note the use of the past tense. On May 12th Odimo sold its Diamond.com domain name and $2MM in diamond and jewelry inventory to competitor Ice.com for $9.5MM. That means one less competitor for diamond-related keywords and forWeb portal deals, which is a positive. Plus it speaks to the barriers to entry in the online jewelry market. Ice.com gains some traffic scale and thus becomes a bigger competitor, but perhaps the deal will imbue incremental keyword rationality into the marketplace.

One specific portal we’re focused on is MSN, which may be one of the more desirable partners for NILE. We believe that Odimo outbid NILE for premium placement on the MSN portal last year, and that that deal expires soon, which means a new replacement could be announced shortly.

3. NILE’sWeb traffic trends are incrementally less bad – In the March quarter, NILE’s traffic in the U.S. declined by approximately 24% Y/Y according to comScore. April traffic appears to be slightly less bad – down 6%Y/Y. The hedges here are twofold: first, its just April data; and second, NILE management has explicitly stated that comScore traffic data is inaccurate. Nevertheless we see it as directionally useful and we’ll continue to monitor comScore traffic trends.

4. Q1:06 International sales may indicate upside to ‘06 estimates – In our March 29th initiation report we highlighted International upside as one of two potential H2:06 revenue growth re-accelerators. March quarter results were encouraging, with revenue of $1.4MM (up 193% Y/Y). Assuming historical patterns hold – i.e., that Q1 revenues are roughly the same percentage of total revenue (roughly 21-22%) – that equates to an annualized run rate of somewhere between $6.3-$6.7MM vs. our ’06 estimate of $5.8MM. And International results should continue to improve as NILE gains traction with consumers and as it rolls out improvements to its U.K. website (such as the new search tool, localized pricing, etc.).

5. High precious metals prices may continue to pressure margins – Precious metals (gold, silver and platinum) are a major component of NILE’s COGS, and precious metals prices have generally increased very sharply YTD following significant increases over the past few years. Below we present recent precious metals pricing trends which we believe may continue to pressure NILE’s margins going forward.

6. More leverage in the model – SG&A was 13.3% of revenue in ’05. Just last week management indicated that, despite current operating efficiencies, its goal is to drive that down to 10% of the total over a multi-year period. We are modeling a very modest decline to 12.8% by 2008, so management’s execution against this goal could provide a source of material upside to our estimates over time.

7. De Beers’Diamond Trading Co. (DTC) upping industry ad spending by 17% in ’06 –We don’t think this is key but more diamond-related advertising should help NILE at the margin. (The DTC is De Beers’marketing arm.) NILE’s core demographic is men, and we all know how suggestible men are nowadays.

8. Weak U.S. results from Tiffany & Co. (NYSE:TIF) – Two key read thrus from TIF’s fiscal year Q1:06 earnings report from May 31st: 1) U.S. retail sales weakness persists; and 2) High precious metals costs continue to pressure margins. TIF’s U.S. retail sales increased just 2% Y/Y and comparable store sales were down 1%Y/Y. (Note that TIF’s Q1 ended April 30th.)

That’s roughly in-line with the company’s March 28th intra-quarter update, and marks a deceleration from the 8% Y/Y growth reported in its fiscal year Q4 (quarter ended January 31st). Plus, TIF “fine tuned” its full-year 2006 expectations, guiding to U.S. retail sales growth of mid-single digit growth vs. high mid-single digit growth previously. File this one under the “for what it’s worth” category because TIF’s U.S. retail sales growth trajectory is the opposite of what transpired at NILE, where growth accelerated Q/Q from 13.5% Y/Y in December to 14.9% Y/Y in March. Moreover NILE management specifically noted that the March quarter strengthened over the course of the Q.

On the margin front, TIF management noted that that sharply higher precious metal costs continue to put pressure on margins. Not a surprise given the chart presented above but it confirms the importance of the metals pricing trends for jewelry retailers like NILE.