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