Description

Blue Nile’s core business is stable, having digested two years of weakness in high end diamond purchasing as well as an overall decline in diamond prices. Nile is now pursuing a differentiated offline strategy that has the potential to re-accelerate the business. At today’s price, you are not paying much, if anything, for this potential.

US engagement has had a difficult 12 month stretch. Comparisons to 2014 are difficult because NILE had an extra week in 2014 which contributed $2.9mm of sales. Diamond prices have declined, pressuring ASPS. And the high end has been weak across the industry. Despite that, the US engagement business has only declined a few percentage points. Units are growing and the company has commented that the high end has stabilized, if only because comps are now manageable. Any uptick in diamond prices or in the health of the high end segment will result in upside. If not, US engagement should grow at low single digit rate going forward.

US non-engagement business is growing nicely. In 2015, it grew 2% and 2016 growth has been accelerating with 2Q16 growth of 5.9%, up from 4.2% in 1Q16. NILE is expanding its assortment and doing a better job of attaching sales to engagement purchasers. For instance, sales of wedding bands are up double digits and have been for 12 of the last 14 quarters. Attachment of engagement purchasers has been increasing steadily, is approaching the mid 40s now, and can growth further. Mix shift to non-engagement is a positive as this business carries higher gross margins than engagement.

International is growing rapidly although that has been somewhat masked by a strong dollar. 2015 growth was 1% y/y but 9.9% y/y ex-fx. That growth has continued in 1Q16 (+4.1% ex-fx) and 2Q16 (9.4%) due to strength in China and the UK. The decline in GBP post Brexit will again pressure reported International growth but the underlying trajectory of the international business is strong.

The key challenge for NILE is that their engagement sales have stalled out despite being only ~5% of the market. Total online penetration in the category is still very low compared to most other retail categories despite having some characteristics that make it attractive for online sales: high ASPs over $1k, low shipping costs, selling commodity products with 3rd party certification (in the case of diamonds). Why is that? The most logical reasons are that people want to see, touch, or feel the product before purchasing and/or because they do not trust an online vendor for such a large purchase. Enter the “web room”.

NILE is in the process of rolling out offline stores – they call them “webrooms” – in malls. These are small, 500-700 sq ft, format stores that are basically showrooms for the BlueNile brand and a subset of its assortment. They are not traditional stores in that they do not carry inventory. When you go to the store, you can see many of the rings, talk to an associate about the product, and place an order – but the order is processed through the BlueNile website and shipped to your home. This is similar to the strategy being pursued by other companies such as Warby Parker and Bonobos. It preserves the best parts of the online business model (low inventory levels, relatively low labor) with the benefits of an in-store retail experience.

So far, NILE has launched 3 webrooms. The first was launched in the Roosevelt Field Mall in NY last year (http://www.bluenile.com/jewelry-stores/store-roosevelt-ny). Two more opened in 2Q, one in Tyson’s Corner and one in Westchester. The company implied on its 2Q16 call that the Roosevelt location is now on pace for ~$7mm in annual sales in 700 sq ft. They also commented that one of the new locations is tracking ahead of Roosevelt and one slightly behind. These are very impressive numbers for a new concept and equate to a sales per sq ft that is several times higher than Tiffany’s. NILE believes that they can ultimately open 25-50 webrooms in the US. If the experience of the first several locations is indicative, this offline strategy could be transformative for the company. 25-50 webrooms performing at this level would increase total company sales by 35-70%.

NILE has been left for dead – few sell-side analysts cover it and it is not on anyone’s radar. NILE trades today at 0.5x EV/Sales and 10.5x EV/EBITDA. The core business does about $14mm of FCF. So you are paying 18x FCF. The balance sheet has no debt and could probably use some leverage. None of this takes into account success in the webroom business. If those continue to perform in-line with the first three stores, NILE could be trading sub 10x FCF looking out two years with a compelling growth story unfolding.

Risks
The engagement business could continue to stagnate
Webrooms could turn out to be cannibalistic -- although the early results are that sales in the surrounding areas increase
Macro could impact sales. Jewelry sales are sensitive to the overall economy. The company commented that 2Q16 sales were weaker than expected due to an unexplained slowdown in June

Catalyst

• Rollout of new webrooms cause acceleration in company's revenues and earnings