Description

Business Description

Blue Nile is a leading online retailer of diamonds, fine jewelry and watches operating (www.bluenile.com, www.bluenile.co.uk, www.bluenile.ca). There is no inventory as the company essentially is the store front for their suppliers and only purchases the diamonds after a customer places an order for a specific diamond. The company has negative working capital as they get paid and then pay their suppliers typically 60-90 days later. This has worked well for a growing revenue base but the magnitude of this benefit will be much smaller should revenues shrink.

Approximately 90% of the business is in the US and 90% of the revenue is diamond related. Competition includes the brick and mortar stores (including independent jewelers, Tiffany & Co and Bailey Banks & Biddle), other online retailers (amazon.com, ebay.com, bidz.com) and department stores (Nordstrom and Neiman Marcus). Blue Nile attempts to play at the higher end of the market with an average order size of around $1,600-$1700. Most of their customers need access to credit for these purchases, which has become more and more difficult. Banc of America and Bill me Later currently provide some financing for purchases on the site.

Short Thesis

- Sales trends have been very weak for Q4 and will likely continue. In their last call, the company said that sales deteriorated since the middle of September and October and were down 20%. As a result the company withdrew Q4 guidance and fiscal 2009 guidance. The average analyst estimate has sales down 10% year over year for Q4 and actually has sales growing 1% for 2009. Comscore showed that Blue Nile had 521k unique visitors in November, down 54% year over year following an October decline of 41% year of year. Note that 35% of sales typically come in the fourth quarter which obviously has not been good for higher priced consumer discretionary purchases. The company could get hit two ways including declining dollar order size as well as declining volumes.

- Falling wholesale diamond prices could hurt their business model in a declining consumer environment. Diamond prices are passed on to customers immediately because of their just-in-time model for purchasing diamonds. The company has begun to see diamond prices decrease over the last several weeks and they believe that such decreases will lead to an increase in the demand for diamond purchases. The Wall Street analyst community has obviously concurred with these historical patterns and has not brought their revenue estimates down enough considering the falloff since September. Given the lack of credit availability, higher unemployment, consumer confidence at their lows, and continued declining home equity values, this is not an ordinary environment so following historical patterns may not work. In this environment, falling diamond prices may not generate increased volumes and therefore revenues could certainly fall as a result. We could have a situation where the company’s revenues drop from declining volumes, declining pricing as well as declining order size. Let’s give the company the benefit of the doubt and assume that the declining volumes that they have been experiencing go flat due to the drop in diamond prices. Should diamond prices go down 10% (volume stays flat) and they continue to make the 20.5% gross margin (cost plus model) then with no other changes, operating profits will go down much more than the declines in prices. Even though gross margins are maintained, the dollars generated are less and therefore operating margins come down significantly as illustrated below in chart 1.

- There is a potential for operating deleveraging. Because of the cost plus business model there is significant operating leverage in the business. In good times, this works quite well as revenues grow operating profits continue to grow because the SG&A does not need to grow as fast as revenues. But operating leverage works both ways so that in bad times you could see a dramatic move downwards in operating income from lowered sales growth. In the last several years, the company has grown revenues dramatically (25%/annum from 2005-2007) but has also invested in SG&A and in particular marketing, customer service and fulfillment. From our conversations with the company, they run the organization lean with 180 employees and don’t expect to make many if any changes here. So, there is a scenario here where gross margins (cost plus) are 20% while SG&A is $42MM so that a 10% decline in revenues hits operating margins by 20%. Using consensus revenue number for 2008 (which arguably are too high); here is the potential scenario:

            Chart 1

Risks

-       Continues to gain mkt share but the market share gains they have already experienced have not offset the declines they have seen in September and October.

o       They are able to offer diamond jewelry at an attractive 20-40% discount to traditional jewelers and are taking share especially from value minded consumers

o       They continue to benefit from size and scale and are the online market leader accounting for 50% of online engagement sales but only 4% of total jewelry engagement sales in US

o       Brick and mortar competitors are closing or are having extremely difficult times but this leads to discounting which may help offset some of the lower pricing benefits Blue Nile is able to offer

-       Generates nice free cash flow given the negative working capital model and has been shareholder friendly purchasing 25% of the shares outstanding since 2005; although they have suspended any further repurchases for now

-       Longer term it’s an interesting long, of course at the right price, given the tailwind related to nice demographic trends (age 25-35); children of baby boomers reach age of marriage and are more accustomed to online purchases, more shopping happening online in general, and the potential for international growth is there

-       Changes in consumer confidence gets people to spend on large discretionary purchases; hard to believe this would change so dramatically in the next 6 months

Catalyst