INVESTMENT THESIS
We are initiating on NILE with a Buy rating and a $41 price target. We highlight several key positives and risks. Key investment positives include:
1. Exposure to the strong secular growth of e-commerce – We estimate a 19% CAGR for U.S. online e-commerce sales from 2005 to 2008;
2. Sizeable and attractive market opportunity – U.S. retail diamond jewelry is a $33B market, while the U.S. diamond engagement segment is a $4.5B market, and both markets contain characteristics that lend themselves to Internet adoption;
3. Leading online market share –We believe that NILE has approximately 50% of the U.S. online diamond engagement market with sales that are approximately 3X the size of the next closest competitor;
4. A leading product/consumer online experience – Per third-party surveys and our own proprietary analysis, we believe that Blue Nile has a leading product/consumer online experience in the jewelry segment;
5. Significant competitive advantage because of supplier relationships – Blue Nile has exclusive Internet distribution rights with suppliers who represent more than half of the available supply of high-quality diamonds in the U.S., and its unique supplier solution lowers the company’s diamond acquisition costs, creates barriers to entry, eliminates the need for physical diamond inventory, and provides an industry-leading selection of approximately 60,000 diamonds for consumers;
6. Attractive cash flow dynamics – NILE’s business model has a materially positive working capital dynamic and low capex requirements, which helped result in a FCF conversion (FCF/EBITDA) of 153% in 2005, the highest FCF conversion in the Internet sector;
7. $100MM share buyback authorization – NILE management recently authorized a $100MM buyback, which at today’s stock prices would amount to 20% of the float; and
8. Material negative sentiment on the shares – As of March 15, there were 5.0MM NILE shares held short, which is the highest level since at least January 2005.
With NILE, we also see several key investment risks:
1. Rising online marketing costs – NILE management stated that its cost-per-click (CPC) rose 50% or more Y/Y for its top keywords in the December quarter;
2. Increasing competition in the online jewelry category –We believe that Blue Nile has been facing increased competition in the online jewelry segment from multichannel jewelry retailers like Tiffany, Zales and Kay Jewelers, as well as from Internet companies like Amazon.com;
3. Comparatively weaker competitive position outside core diamond engagement segment – Blue Nile’s competitive position is somewhat weaker for non-engagement diamond jewelry (18% of sales) and non-diamond jewelry (10% of sales), and NILE has to take on inventory for many of these products;
4. Very limited international exposure to date – One of our consistent themes for the Nets has been that international exposure is key to long-term growth, and NILE’s nascent U.K. and Canadian operations amounted to just 1.6% of sales in 2005;
5. Recent uncertainty over management’s ability to forecast – The December 2005 quarter was the first quarter in which the company missed its revenue guidance, reporting $73.2MM vs. a guidance range of $75-$82MM; and
6. Rising diamond costs – Diamond prices continue to increase (albeit more modestly than in prior years), which could limit the industry’s overall sales growth or negatively impact Blue Nile’s competitive price advantage.
Our Price Target
We arrive at our $41 target price for NILE based on a combination of EV/EBITDA and P/E analysis. Our P/E analysis generates a price target of $41, while our EV/EBITDA analysis generates a price target of $40. Our $41 price target averages the two and rounds up because we weight the P/E multiple more heavily for e-commerce names like NILE. For P/E, We apply a 38X multiple to our C2007 proforma EPS estimate of $1.08 to reach a $41 target price. (Our proforma EPS estimate adds back non-cash stock compensation charges, adjusted for taxes, which is consistent with our methodology for other Internet stocks.) For EV/EBITDA, we apply a 21X multiple to our 2007 EBITDA estimate of $28.4MM ($1.54 per share) to reach a $40 target price, adjusting for $133MM ($7.31 per share) in year-end 2006 net cash. A key point on NILE’s valuation is that its FCF/EBITDA conversion level (153% in 2005) is the highest in the Internet sector and 2X that of the industry average. We believe this factor is underappreciated by the market and argues for a slightly higher than group average multiple relative to NILE’s growth rate. Essentially, with the highest FCF conversion in the sector, we believe that NILE’s superior quality of earnings warrants a relatively high multiple.
In terms of the stock call, ours is not a March quarter call. Our $0.12 EPS estimate is inline with consensus and in-line with the company’s $0.11-$0.12 guidance range. Our $48.4MM revenue estimate is below the Street at $50.0MM, but within the company’s $47- $49MM guidance range. Intra-quarter checks indicate that search pricing remains strong in the diamond jewelry segment, but we believe this is fully incorporated in the company’s guidance and in estimates. And our conversion analysis of QTD U.S.Web traffic data indicates neither material upside nor downside to our unit estimate. Initiating at this late date in the quarter, we believe NILE is on track for an In-Line quarter. But we believe that the stock’s high FCF yield and the company’s stock buyback plans (including the fact that it bought back stock at $33 in the December quarter) provide significant support for the shares at today’s level. And we believe that H2:06 Y/Y margin expansion and revenue growth acceleration (the causes of which are detailed in this report) will provide the catalyst for the shares.
Citigroup analyst Mark Mahaney initiated coverage on Blue Nile (