Blue Nile NILE S
October 08, 2009 - 3:24pm EST by
juice835
2009 2010
Price: 63.43 EPS $0.80 $0.88
Shares Out. (in M): 15 P/E 79.3x 72.1x
Market Cap (in M): 919 P/FCF 79.3x 72.1x
Net Debt (in M): -47 EBIT 0 0
TEV: 872 TEV/EBIT 31.0x 29.0x
Borrow Cost: NA

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Description

This is a follow-up to SKCA74's well written but badly performing Blue Nile short pitch last year. He offered the usual business description and outline of the short case which largely still apply so I will keep this short and not be repetitive. The main difference between then and now, however, is that a valuation that was perhaps only moderately stretched has become outrageously so. Seriously, there is no way to justify the stock price of this company under any reasonable valuation framework. I suspect insiders would privately agree with that conclusion having been steady sellers of late. Unfortunately, there is also really no catalyst to pop the air in the valuation but, nevertheless, the valuation is so egregious that I believe it will over time come to be recognized as such and, thus, will work eventually from this entry point.

Qualitative Thoughts on the Business:

NILE is a good business for many of the reasons cited by SKCA. Most importantly, the company has a lower cost structure than bricks & mortar retail competitors given its lack of stores. I don't deny that the share of online sales of diamonds will continue to increase going forward though at least a good chunk of that share growth is behind us at this point. Further, the company has good relationships with many of its suppliers. Specifically, the company has exclusivity over the specific stones that are offered from a supplier on its site (basically you won't find that particular stone anywhere else). I am skeptical that this model, despite it being attractive, is completely impenetrable over the long term. They have a good and valuable brand and a big head start on their online brethren but I am suspicious that this will necessarily continue into infinity and the price of the stock most certainly assumes that at a minimum.

So what is this worth?

- Valuation: The company is guiding for total 2009 revenue of around $290mm producing EPS of 78-82 cents. This puts valuation at a cool 80x current year or 75x backing out the cash (company has no debt) or 48x LTM EBITDA.  For some context, the high end of their revenue guidance is roughly similar to 2008 actual which is pretty impressive given the timing of the economic crisis, etc. I don't deny that the business has held up well on a relative basis probably owing to the continued market share picked by the online channel.

- Valuation Vs Stage of Maturation: I don't deny that some companies if they truly have spectacular growth in front of them deserve to trade at multiples such as the one cited above. This company's growth prospects, however, simply don't realistically reflect NILE's likely trajectory. This can be triangulated upon a few different ways:

1) In the three years ending 2007 where this company had every possible factor working in their favor (best consumer credit / demand environment perhaps ever, much smaller base, etc.) the company grew both revenue and EPS (EBITDA margins declined over that time) around 24% / year. Again this was in probably the most favorable environment possible which is not likely to recur in that form anytime soon. Nevertheless, if you assume 24% for the next three years which i think is EXTREMELY unlikely given the change of consumer mindset, rising unemployment, sales this year down mid single digits, this stock would still trade at 40x 2012 earnings. As for what type of growth the company is likely to achieve once the world gets back to some measure of normal, the CEO said at a conference in September that it is their expectation that they can achieve "double-digit revenue growth." Again that type of growth is great but nowhere near what is needed to sustain the current valuation.

2) Looking at it a different way, we asked the company what they think is ultimately possible in terms of market size, share and margins. It is important to note that around 2/3 of the company's revenue is from engagement rings so it is still something of a niche business that they haven't found a way to break out of during their existence to date (pretty good time sample). The company thinks that, way down the line, they can grow revenues well north of a billion dollars from (say 3-4x current levels) and increase EBITDA margins which have been steadily declining since 2005 from current LTM level of 6.1% to perhaps double that amount. What would that get you in this far out bull case scenario? If the company can achieve say $130mm in EBITDA a decade from now (LTM figure is $18mm), the stock at current levels would still be trading almost 7x EBITDA! The company also likes to stress its long-term international potential (around 10% revenue currently) but this is likely overstated given that they have had limited success thus far and only recently even managed to get certain of their foreign sites translated into local languages. This is pretty telling given the maturation of online retailing both home and abroad.

In terms of what a reasonable valuation might be, I would argue that something like $40 per share (still at 30x 2012 earnings assuming 15% EPS growth per year) would account for all of this company's positive attributes and opportunities. 

What do insiders think of the valuation? i think this summary from yahoo sums up their bearishness pretty well: http://finance.yahoo.com/q/it?s=NILE

So is this just a short squeeze? It doesn't appear to be a classic short squeeze. There is a large short interest (3.1mm shares according to bloomberg) of approximately 21% of shares outstanding but it is quite easy to borrow (negative rebate of around 2%). I'm sure technical factors have played a role in the recent run-up but they don't seem to be the dominant forces here. 

 

 

Catalyst

Market realization that this company hasn't ever grown at 40% per year and certainly won't do so anytime soon.

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    Description

    This is a follow-up to SKCA74's well written but badly performing Blue Nile short pitch last year. He offered the usual business description and outline of the short case which largely still apply so I will keep this short and not be repetitive. The main difference between then and now, however, is that a valuation that was perhaps only moderately stretched has become outrageously so. Seriously, there is no way to justify the stock price of this company under any reasonable valuation framework. I suspect insiders would privately agree with that conclusion having been steady sellers of late. Unfortunately, there is also really no catalyst to pop the air in the valuation but, nevertheless, the valuation is so egregious that I believe it will over time come to be recognized as such and, thus, will work eventually from this entry point.

    Qualitative Thoughts on the Business:

    NILE is a good business for many of the reasons cited by SKCA. Most importantly, the company has a lower cost structure than bricks & mortar retail competitors given its lack of stores. I don't deny that the share of online sales of diamonds will continue to increase going forward though at least a good chunk of that share growth is behind us at this point. Further, the company has good relationships with many of its suppliers. Specifically, the company has exclusivity over the specific stones that are offered from a supplier on its site (basically you won't find that particular stone anywhere else). I am skeptical that this model, despite it being attractive, is completely impenetrable over the long term. They have a good and valuable brand and a big head start on their online brethren but I am suspicious that this will necessarily continue into infinity and the price of the stock most certainly assumes that at a minimum.

    So what is this worth?

    - Valuation: The company is guiding for total 2009 revenue of around $290mm producing EPS of 78-82 cents. This puts valuation at a cool 80x current year or 75x backing out the cash (company has no debt) or 48x LTM EBITDA.  For some context, the high end of their revenue guidance is roughly similar to 2008 actual which is pretty impressive given the timing of the economic crisis, etc. I don't deny that the business has held up well on a relative basis probably owing to the continued market share picked by the online channel.

    - Valuation Vs Stage of Maturation: I don't deny that some companies if they truly have spectacular growth in front of them deserve to trade at multiples such as the one cited above. This company's growth prospects, however, simply don't realistically reflect NILE's likely trajectory. This can be triangulated upon a few different ways:

    1) In the three years ending 2007 where this company had every possible factor working in their favor (best consumer credit / demand environment perhaps ever, much smaller base, etc.) the company grew both revenue and EPS (EBITDA margins declined over that time) around 24% / year. Again this was in probably the most favorable environment possible which is not likely to recur in that form anytime soon. Nevertheless, if you assume 24% for the next three years which i think is EXTREMELY unlikely given the change of consumer mindset, rising unemployment, sales this year down mid single digits, this stock would still trade at 40x 2012 earnings. As for what type of growth the company is likely to achieve once the world gets back to some measure of normal, the CEO said at a conference in September that it is their expectation that they can achieve "double-digit revenue growth." Again that type of growth is great but nowhere near what is needed to sustain the current valuation.

    2) Looking at it a different way, we asked the company what they think is ultimately possible in terms of market size, share and margins. It is important to note that around 2/3 of the company's revenue is from engagement rings so it is still something of a niche business that they haven't found a way to break out of during their existence to date (pretty good time sample). The company thinks that, way down the line, they can grow revenues well north of a billion dollars from (say 3-4x current levels) and increase EBITDA margins which have been steadily declining since 2005 from current LTM level of 6.1% to perhaps double that amount. What would that get you in this far out bull case scenario? If the company can achieve say $130mm in EBITDA a decade from now (LTM figure is $18mm), the stock at current levels would still be trading almost 7x EBITDA! The company also likes to stress its long-term international potential (around 10% revenue currently) but this is likely overstated given that they have had limited success thus far and only recently even managed to get certain of their foreign sites translated into local languages. This is pretty telling given the maturation of online retailing both home and abroad.

    In terms of what a reasonable valuation might be, I would argue that something like $40 per share (still at 30x 2012 earnings assuming 15% EPS growth per year) would account for all of this company's positive attributes and opportunities. 

    What do insiders think of the valuation? i think this summary from yahoo sums up their bearishness pretty well: http://finance.yahoo.com/q/it?s=NILE

    So is this just a short squeeze? It doesn't appear to be a classic short squeeze. There is a large short interest (3.1mm shares according to bloomberg) of approximately 21% of shares outstanding but it is quite easy to borrow (negative rebate of around 2%). I'm sure technical factors have played a role in the recent run-up but they don't seem to be the dominant forces here. 

     

     

    Catalyst

    Market realization that this company hasn't ever grown at 40% per year and certainly won't do so anytime soon.

    Messages


    SubjectRE: FCF Conversion
    Entry10/09/2009 03:13 PM
    Memberjuice835

    i agree that the positive working capital cycle can lead to enhanced FCF particularly when bus is growing but given that this company has no way of really generating excess returns on the cash they hold (they generally just plow it into stock buybacks at absurd valuations), i dont see how this could lead to a sustainable multiplier of 2x on earnings. think of what kind of bang that implies! also, in flat - down years like '08 this can / will partially reverse out. if there is some conceptual thing im missing about how impactful this can be, love to hear your explanation.


    SubjectVadon's sales
    Entry10/09/2009 09:18 PM
    Membersfdoj

    I would add that NILE's founder, Chairman and 8-year CEO, Mark Vadon, currently the 12th largest owner of the stock, has been a very astute seller since the company's IPO in May 2004. Since that time he has sold approximately 81% of his original shares, about 1.1mm total at an average price of $65.42 per share versus the stock's average price of $40.94 since the IPO, a 60% premium. His pattern has been to sell small amounts regularly, and large amounts occasionally. As recently as February 2007 he still owned 65% of his original stake in the company, but between 5/10/07 and 8/31/07 he sold 750k shares at an average price of about $76/share. The stock peaked on 10/9/07 at $100.50--Vadon's highest sales were for $92 on 8/9/07. His regular sales ceased as of February 2007, and he hadn't made any sales after those just mentioned in late 2007, until he sold 137k shares in early June of 2009 at an average price of $49/share. Over the following month the stock fell -25% versus -5% for the S&P and -4% for Nasdaq.

    So a potential catalyst could be if Vadon sells any of his remaining 371k shares.

    In response to greenshoes, using numbers taken from Bloomberg, the cumulative FCF from 2002-2008 was $161mm versus the the cumulative NI of $94mm, for a FCF/NI ratio of 1.7. Applying this multiple to 2010's street estimate for NI of $14.6mm yields an estimated 2010 FCF of $25mm on a market cap of $61 x 15.8mm FD shrs = $961mm for a FCF yield of 2.6%. Echoing juice835, this valuation implies a 15+% growth rate for the next 5 years. NILE grew FCF at an 18% clip from 2002 through 2008, but that was on a smaller base, during an era of unprecedented consumerism. It doesn't seem impossible they could replicate that growth over the next few years if everything goes right, but the probability seems quite low. If we take a slightly different period than the most favorable 02-08 era, and look instead at 2004-2010e, FCF CAGR is instead about -2%. Given that 91% of 2008 sales were in the US, one would need to assume that sales grow fast enough abroad and NILE gains market share quickly enough in the US to offset the deleveraging consumer and subdued spending which is generally not expected to increase in the near term, let alone grow at a double digit pace. That is a different bet and a more difficult prospect than the bet in 2002 on NILE riding a credit boom and rapidly increasing acceptance of the internet commerce.

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