Stifel Nicolaus Internet analyst Scott Devitt on Blue Nile's Q4 earnings results:
Rational Managers in an Irrational Environment; Maintain Hold
• We rate shares of Blue Nile Hold. We believe Blue Nile is an outstanding business with an impressive management team. In the near term, we believe the shares will be under pressure due to a material deceleration in the year-over-year revenue growth rate; however, investors interested in a business with solid management, a negative cash conversion cycle, an operating expense structure less than 30% of its peers, with a buyback in place that for almost 17% of the market capitalization (on after hours pricing), should begin paying attention, in our view.
• Blue Nile reported 4Q05 revenues of $73.2 million and EPS of $0.29, compared to our estimate of $81.0 million in revenue and $0.33 in EPS.
• TTM free cash flow increased 8.2% year/year to $30.2 million. We expect full-year 2006 free cash flow in the area of $30 million due to the full utilization of the NOL by the end of 1Q06.
• Gross margin in the quarter came in at 22.2%, slightly above our estimate of 22.0%, and driven by product mix shift towards non-engagement products which carry a higher gross margin component.
• For full year 2006, management expects net sales to be between $220 million and $245 million with net income per diluted share of $0.62 to $0.72. These EPS figures include the impact of FAS 123R, which would equate to about $0.14 to $0.16 per share.
• For 2006, we are expecting revenue of $229 million; cash EPS of $0.81 and GAAP EPS (including stock option expense) of $0.65. For 2007, we are expecting revenue of $260.7 million and cash EPS of $1.00.
Blue Nile reported a surprisingly weak 4Q05, in our view, blaming both weak jewelry industry fundamentals and what CEO Mark Vadon called irrational pricing in the pay per click advertising market (although we will continue to believe he said "eRational"). On the conference call, Mr. Vadon stated, "We saw extremely aggressive increases in the cost of online advertising. Our cost per click on Google for example, rose by over 50% from a year earlier. While the cost of online marketing grew significantly in Q4, we remain disciplined in our spending, in order to maintain profitability on new customers rather than to chase unprofitable growth, as some of our competitors have done." We believe the company has very solid management, and admire their focus on profitable growth in an industry in which many will spend advertising dollars without any focus on the returns. Please see our research on Google over the past month for our thoughts on the escalating costs of PPC (hint: we believe they are not sustainable). Blue Nile's discipline as it relates to marketing reminds us of Warren Buffett's discussions in early shareholder letters (post partnership, late 1970s) about the discipline of his insurance company managers in times of irrational, unprofitable pricing of insurance policies.
In the case of Blue Nile, a search today within Google for "engagement ring" yields a top result of wherethediamondsare.com, which is not a retailer but a sales and marketing arm for the diamond industry. Other results on page one of the search yield jewelers we have never heard of, nor probably ever will. Many small jewelers have begun to beta test Google in an effort to stem the market shares losses that have occurred in the industry due to the Blue Nile effect. There is a need for trust when purchasing a $6,000 engagement ring over the internet, so the opportunity for small jewelers on the internet is limited over the long-term, in our view. We believe the diamond industry fragmentation and the need for trust require an aggregation point which is trusted such as Blue Nile or Amazon. We view the weak results by Blue Nile as the effect of the rush toward the internet of less rational business owners in fear over there own inefficient business models. Nonetheless, Blue Nile's numbers were not pretty versus expectations and given the management teams nature, we think the forward guidance was appropriately conservative. We believe the fourth quarter is an example of manageable change, although we are changing our 3-year growth rate for revenue to 15% from 20%. We believe, as the company modifies its marketing strategy, our revenue growth expectations could move closer to the prior 20% figure.
There are many things we like about Blue Nile – (1) management; (2) operating expense structure; (3) direct-to-consumer model; (4) negative cash conversion cycle; (5) outstanding cash-generating characteristics; (5) low capital requirements; and (6) efficient allocation of capital (buybacks). Our expectations for the business were too high and investors are paying for that in the near-term but, as the new news is priced in, we become buyers in the upper-$20s or around 15x EV/ unlevered free cash flow on 2006 estimates.
We continue to believe that Blue Nile is a very strategic acquisition candidate given its unique, direct-to-consumer business model and its supplier relationships. We mention Amazon, which both owns inventory and offers marketplace services in all retail categories, as we believe the FCF characteristics mesh and we believe the marriage of an under-branded business with Amazon's 55 million active customers would have a material positive impact on Blue Nile's sales. We also believe both IAC/Interactive and Liberty Media to have shown their hand in terms of the strategies for HSN and QVC, respectively. Just as Cornerstone and Shoebuy made sense to HSN and Provide Commerce made sense to Liberty, so does Blue Nile to either, in our view.