|Shares Out. (in M):||13||P/E||41.2x||0.0x|
|Market Cap (in $M):||444||P/FCF||24.8x||0.0x|
|Net Debt (in $M):||-120||EBIT||14||0|
|TEV (in $M):||325||TEV/EBIT||22.7x||0.0x|
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BLUE NILE (NASDAQ:NILE)
Blue Nile (“NILE”) is a Seattle-based online retailer, specializing in customized diamond jewelry. The company possesses the largest inventory of certified diamonds in the world and dominates the online engagement ring category with over 50% market share. Unlike traditional brick and mortar jewelers, NILE’s exclusive supply relationships and efficient cost structure enables the Company to pass its savings onto customers, charging 20-40% less than its competition. With access to over 135,000 certified diamonds and dozens of settings, engagement ring customers can create truly unique rings without the egregious markup.
NILE is a world class franchise whose current valuation disregards three key developments: improving wedding band attachment rates, a burgeoning China business, and critical mass in network effects.
Poor sentiment, short term anxiety, and high short interest provide an excellent setup for a bargain purchase of a franchise business. With a P/E of 41x, ostensibly rich multiples repel “value” investors who often bypass opportunities that are not headline cheap. Similarly, a recent slowdown in sales growth disheartens even the most optimistic “growth” investors. Meanwhile, short sellers, whose interest comprise roughly 10.5% of current shares outstanding, assert that NILE’s share price is simply too high. While the shorts do not doubt the long term viability of NILE’s business model, their valuations are anchored on trailing results and near term expectations. Collectively, their apprehensions are reaffirmed in their minds by NILE’s recent fourth quarter earnings miss and reduced guidance, which sent shares tumbling 15% on February 6, 2014. Guided by our strongly held views of NILE’s long term intrinsic value and the sustainability of its superior business model, we feel comfortable purchasing a quality business at the only time quality goes on sale—when there is pervasive fear and uncertainty in the marketplace.
WHAT WE LIKE ABOUT NILE
NILE is the dominant online jewelry retailer, commanding over 50% of the online engagement ring market. The company possesses favorable and improving economics and maintains a clear competitive advantage by providing consumers with the best product offering at the lowest cost.
Competitive Advantage: Low Cost Provider
NILE’s competitive advantage is selling quality diamond jewelry at the most affordable price. It maintains this low-cost advantage by operating an efficient costs structure and by passing these cost-savings to its customers. While competitors invest in expensive store fronts, pay out commissions to sales associates, and purchase costly inventory, NILE does none of these. The business generates $450 million in revenues from sales in over 40 countries out of three offices and two fulfillment centers. NILE accomplishes this with less than 300 employees, including knowledgeable and friendly associates—available 24/7 in six languages—who take no commission. Lastly, NILE has developed exclusive relationships with over 100 suppliers, enabling it to manufacture jewelry on a just-in-time basis.
This last point is unique to NILE and deserves further exploration. By ordering polished diamonds on a just-in-time basis, NILE forgoes tying up capital in purchasing and holding very expensive inventory. Because vendor payment terms range from 30-120 days, while customer payments are typically received upon purchase, NILE also benefits from negative working capital. Most importantly, NILE’s virtual inventory of over 135, 000 diamonds ensures that customers are getting a vast selection of diamonds at the best possible price. This virtual inventory is essentially an online diamond exchange, pitting one seller versus the other and allowing the laws of supply and demand to set the most efficient price. Assuming all consumers are rational economic agents, vendors who sell comparable diamonds at a premium will have to reduce prices in order to sell their goods (why would anyone spend x+1 if they could purchase the same exact diamond, as governed by the “four C’s,” for x?). We can witness NILE’s low cost advantage in real-time below:
First, comparing NILE’s inventory to Zales’, NILE has a far greater selection. A search for a round 1-carat, ideally cut (EX), colorless (D) diamond of internally flawless (IF) clarity returned one diamond on Zales’ website, which cost $22,966. NILE on the other hand, returned 14 results with prices ranging from $16,085 to $23,513.
Second, because the 14 diamonds listed on NILE’s “exchange” are essentially the same, consumers will naturally gravitate toward the most affordable option. After all, each and every one of these diamonds has been certified by the GIA (Gemological Institute of America), and NILE does not sell any synthetics. As a result, suppliers will have to match prices if they want to turn their inventory, resulting in more competitively priced diamonds for the consumer.
SUPERIOR PROFITABILITY AND CASH FLOW
Existence of a competitive advantage becomes more compelling when we look at the industry’s profitability.
In nearly every year for the past decade, NILE has generated higher levels of return on capital and return on equity than its publicly traded jewelry peers. NILE’s average return on capital and return on equity during this time period was 24.8% and 28.6%, compared to an average of 8.4% and 6.5% for the peer group, respectively.
NILE’s unique capital light business model also results in a highly cash generative business, producing cash flows that are many multiples of its net income.
In the past decade, NILE has generated, on average, free cash flows of 2.2x its earnings compared to 0.5x for its peers. These levels of returns and cash flows can only be realized with a business model like NILE’s, where only limited amounts of capital are tied up in stores and inventory, and where a smaller level of employees can support the business. With only 291 employees, NILE generated $1.55 million in sales per employee, compared to $0.38 million, $0.16 million, and $0.23 million for Tiffany & Co., Zales, and Signet, respectively.
Strongest Competitive Position in Favorable Industry
NILE competes in an industry in which no substitutes exist. People will always get married, and proposals will always be sealed with an engagement ring. In other words, unlike other retail industries, which are extremely vulnerable to fashion risk, the engagement ring market will never face obsolescence.
Additionally, major consolidation in the jewelry industry has improved the competitive landscape for existing players. According to industry data compiled by the Jewelers Board of Trade, 26,754 jewelry retailers operated in the US in 1999, the year NILE was founded. That number has declined by nearly 20% to 21,646 retailers in 2013. During this same period, the US population has grown by 13% according to US Census Bureau statistics. The largest retailers have experienced similar consolidation. In the past decade, five of the top 10 largest national jewelry chains have either been acquired or gone out of business1. Signet’s (February 2014) announced acquisition of Zales combines the two largest brick and mortar jewelry retailers in in the United States and reaffirms this trend.
Furthermore, store closures, cost cutting, and consolidation on the part of the brick and mortar jewelers are defensive moves. Winners in retail play offense—not defense. As a result, many retailers are expanding their online capabilities—an offensive move—and mimicking the customization of NILE’s “Build Your Own” features. This is economics 101: the existence of above average profitability will attract competition. While some economists-types may argue that this will ultimately lead to declining economic profits for NILE, we see this as a validation of NILE’s competitive position. Moreover, borrowing from management theories, organizational legitimacy leads to industry creation. In other words, the growing presence of online jewelry will lend greater credibility to the online jewelry market and remove the psychological barriers associated with expensive online purchases, creating a larger pie for all participants.
Best-in-Class Customer Service & Leading Resource for Diamond Ring Education
NILE has some of the best customer service of all retailers, with a Bizrate.com rating of 9.1 out of 10.0 and a Net Promotion Score of over 80. NILE’s friendly and knowledgeable associates, who are available 24/7 in over six languages, are critical to NILE’s success; an online jeweler without this capability is certainly doomed to failure. Unlike other retailers, NILE’s associates are not commissioned and have no incentive to upsell potential clients, who can make their purchases in a no-pressure environment. During my conversations with NILE’s jewelry consultants, I was advised on several cost saving tips, such as purchasing a 0.98 carat diamond ring versus a 1.0 carat diamond—a size difference undetected by the naked eye. Such incentives do not exist when commissions are at stake.
NILE also has industry leading diamond education resources. When searching the words “diamond education” on Google, bluenile.com is the first result. Though I have no way of verifying this, I would argue that more people learn about the “four C’s” from bluenile.com than from any other resource. Anecdotally, we spoke with several newlyweds who were referred to bluenile.com by their independent jewelers for its high quality education resources.
Coveted Consumer Demographic
NILE holds retail’s most coveted consumer demographic: young, educated, and high income. Its primary consumer is typically between the ages 25-34, has a bachelor’s or post-graduate degree, and earns over a six-figure salary. Retailers explicitly target this demographic and devote their marketing dollars toward retaining these high lifetime value customers2. While Zales and Tiffany & Co. sell across the demographic spectrum, NILE focuses on this particular consumer and is better positioned to benefit from recurring sales. NILE’s 25 year old consumer, pleased with his initial engagement ring purchase, will likely turn to NILE for future jewelry purchases during his next half century of expected life.
WHAT THE MARKET IS MISSING
The market is missing three key developments that are not reflected in the current share price: improvement in wedding band attachment rates, hidden value in the China franchise, and critical mass in network effects.
Wedding Band Attachment Rate
The largest barrier for NILE’s engagement ring customer is making such an emotion and valuable purchase without seeing the merchandise in person. However, once this barrier is crossed, converting this customer to a complementary Blue Nile wedding band is significantly more likely. As a result, NILE is focused on capturing this wedding band opportunity, a $4 billion market that carries margins double that of engagement rings, in what is a low risk, high return strategy for the business. By targeting marketing investments and developing the “band matcher” concept, which suggests two to five bands for every engagement transaction, NILE will leverage its core engagement customer to drive wedding band sales.
NILE’s current attachment rates, the rates at which customers purchase wedding bands from the same engagement ring retailer, is roughly 35%—slightly more than half the industry average of 63%3. Despite NILE’s focus on this product, the market ascribes no value to improving wedding bands attachment rates.
The tables below illustrate our estimate of NILE’s current EPS contribution from its wedding band business at varying attachment rates.
In 2013, we estimate wedding band earnings contributed $0.25 per share. Looking beyond 2013, the consensus forecasts no improvement in wedding band attachment rates. Assuming NILE’s engagement segment grows to $420 million by 2016—which is consistent with the consensus top-line CAGR of ~10%—and attachment rates reach industry average levels of 60%, EPS contribution from wedding bands alone would be $0.71 per share.
At $1.37, the consensus EPS disregards any possibility of improving attachment rates and neglects the traction this product segment has recently achieved. At an investor conference in March 2014, CFO David Binder confirmed that growth in wedding bands sales were the fastest among all product categories. With increased product awareness, marketing investment, and by introducing features such as the “band matcher,” there is no reason NILE’s core customer—the young, educated, wealthy male (who is already a happy customer)—would not purchase a complementary wedding band at rates similar to the industry average.
The value of NILE’s China business, which is currently producing ~$30 million in sales compared to nearly zero in sales three years ago, is underestimated by the Street and is not reflected in the current stock price. For illustrative purposes, the following table lists valuations for other high growth Chinese companies:
Based on relative valuation metrics, growth rates, and the legitimacy of the company, NILE’s China segment should be worth at least the median multiple of 3.8x revenue, or $114 million, which is more than a third of NILE’s current enterprise value. If NILE were to reach its stated goal of $100 million in sales by 2016 (~49% CAGR 2013-2016), NILE’s China segment would be worth $190 million using similar analyses, resulting in a valuation more than half of NILE’s entire current enterprise value. Additionally, one could argue that NILE’s China business should be valued at a premium to its Chinese counterparts, which lack an American brand name and whose financial statements are perceived as less reliable. Viewed from a different lens, if NILE China was a standalone entity and was IPO’d today, there is no scenario in which its equity gets less than a $100 million valuation.
IMAX recently sold a 20% stake in its China business, which grew sales 26% year-over-year, for $80 million, or a 7.1x sales multiple. While this business is different from NILE’s, we can begin to understand what investors are willing to pay for opportunities in China. NILE, which only entered Mainland China in 2011, grew its business to ~$30 million in 2013. If the company were to reach its goal of $100 million in sales by 2016, which implies a ~49% CAGR, it would not be inconceivable for NILE to command similar valuations.
Below is a more detailed analysis of the why China is the most attractive new market for NILE and why NILE is best positioned to capitalize:
China’s Tremendous Engagement Market
Over 13 million marriages occur in China each year. This is nearly six times the annual number of marriages that occur in the US. Naturally, this makes China’s addressable engagement ring market much larger as well. According to NILE, China’s engagement ring market is roughly $8 billion compared to $5 billion in the US. Chow Tai Fook, China’s largest jewelry retailer, says the nation’s addressable market is $10-$20 billion4. Even attaining a sliver of this colossal pie would be a major impact to NILE’s earnings power.
This opportunity is not available to all of NILE’s competitors—nor is it a priority for them—giving NILE an important first-mover advantage. NILE has been in China for over three years now, starting with joining the Shanghai Diamond Exchange in early 2011. Since then, NILE has built both simplified and traditional Chinese language websites, acquired local distribution and fulfilment capabilities, and has hired local employees who truly understand China’s numerous languages, varied customs, and jewelry culture. NILE’s most significant milestone was achieved earlier this year when the Company acquired a license to sell jewelry direct-to-consumer as opposed to through a third-party.
James Allen, NILE’s closest competitor, currently has no business in China. Similarly, Brilliant Earth, another online competitor, offers shipping to China, but this is as far as its reach goes. Neither of these players have Chinese websites, Chinese-speaking associates, nor local distribution and fulfillment capabilities, which cannot be built overnight.
Compared with traditional, brick and mortar jewelry retailers, NILE is able to leverage its current, global supply chain infrastructure and does not need to invest in physical store fronts to achieve sales growth. Moreover, NILE already possesses the largest, exclusive inventory of GIA certified diamonds in the world. Having recently acquired licenses to sell directly in China, NILE is now able to offer Chinese consumers access to the same exclusive global diamond supply and transparent pricing we have in the States. A quick search through NILE’s US and Chinese websites confirms this:
According to a Bain & Company research on Chinese e-commerce, more than 70% of survey respondents say they price-compare before finalizing a purchase5. The same research also states the overwhelming concern of the Chinese consumer is being sold fake products. In other words, the Chinese—like everyone else—appreciate quality at fair price. Equipped with a direct-to-consumer sales license, NILE is now capable of offering access to over 135,000 diamonds—all of which are certified (NILE does not sell synthetics, either)—in its virtual inventory to these consumers and will benefit from continued growth in the region.
Growing Diamond Market in China
China is the fastest growing diamond market in the world, where diamond retail jewelry sales increased at a 27% CAGR from 2006 to 2012. This compares with a 4% decline in the United States, a 5% decline in Europe, and a 9% decline in Japan during the same period6.
While gold remains the most important jewelry category in China, diamond jewelry is the fastest growing. This growth stems primarily from China’s burgeoning middle class, who purchase diamond jewelry to communicate their achievements and status. As the Chinese middle-class continues to expand, and as Chinese millennials increasingly adopt western wedding practices, diamond jewelry purchases will continue to grow. According to Bain & Company’s Global Diamond Report 2013, China is expected to account for approximated a third of the global diamond demand by 2023.
China has the world’s largest online population, with nearly 600 million internet and 500 million mobile internet users—nearly twice that of the entire US population7. As a result, China also has the world’s largest e-commerce market, with over $300 billion in transactions in 2013. To put the size of China’s internet retail market in perspective, sales on China’s “Singles Day” reached $5.7 billion—that’s nearly 2.5 times the sales generated on US’s Cyber Monday8. By 2020, China’s e-commerce market is expected to be larger than that of the US, Japan, Britain, Germany, and France—combined9.
The confluence of China’s growing diamond market and China’s enormous e-tailing market provides an ideal dynamic for NILE’s international expansion. With a growing middle class and internet penetration at only 44%, NILE will enjoy long-term favorable economics from China. This opportunity is not ascribed value at the current share price.
Engagement rings are driven by referrals. The consumer who is about to spend thousands of dollars on a ring is likely to consult his married friends and draw from their ring-buying experiences before finalizing his purchase. According to NILE, two-thirds of engagement ring customers make their purchases this way. With a Net Promoter Score*of over 80—and product returns at nearly 0%—NILE’s satisfied customer base is the ideal platform for referral business (Net Promoter Scores for other respected retail names: Costco - 82, Apple Laptops - 72, Amazon - 64)10.
At over 360,000 engagement rings sold, NILE’s has reached critical mass in its consumer base where an increasing level of referrals will lead to positive network effects. While there is no accurate way to measure this effect on NILE’s profitability, consider the following example: assume that for every 10,000 couples who purchase an engagement ring, a thousand couples successfully convert one friend, resulting in a new referral base of 11,000. While this incremental consumption is small at low base levels, it becomes increasingly large as the referral base grows.
At the same 10% conversion rate, NILE’s current referral base can lead to over 36,000 additional customers. At an average engagement ring price of $6,000, that is $216 million in potential sales. This dynamic becomes even more powerful when considering the potential lifetime value of this growing customer base (Valentine’s, anniversaries, birthday gifts from the groom and fashion jewelry purchases from the bride).
This network effect goes beyond traditional word-of-mouth into social networking sites such as Pinterest, where NILE is the most followed, liked, and pinned jeweler.
NILE’s ~62,000 followers not only increase the company’s brand recognition, they also create the ideal platform for additional business. One study suggests that Pinterest accounts for 23% of social-mediated e-commerce11. This is second to only Facebook, which—at 1.23 billion accounts—has 18x the user base12. When combined with overseas growth and consolidation in the jewelry industry, these dynamics create powerful effects simultaneously working in NILE’s favor.
Sum of the Parts
Our sum of the parts analysis reflects the purchase price we would pay today to acquire the business in three distinct parts:
1) Blue Nile ex China
2) Wedding Bands at Industry Average Attachment Rates
3) Blue Nile China
We apply EBITDA multiples based off competitors listed in NILE’s 10-K to its non-Chinese business. Based on our analysis and management’s comments, NILE’s China sales in 2013 were ~$30 million, or 7% of total sales. Assuming NILE China contributed 15% of total EBITDA—more than double its proportion of sales—the remaining 85% attributed to NILE ex China amounts to $14.8 million.