Brief Overview

Blue Nile has been a popular short since it came public and has been written up for VIC twice since then, I will refer you to those well written pieces for the backbone of the story.  The crux of the short thesis has typically been valuation, however, over the past two quarters the business has taken an ugly fundamental turn for the worse.  After reporting terrible Q4 results and 2012 guidance the stock traded below $30 in the after hours and due to the tight float and a sell side upgrade its has recovered to almost $39.  From here I see at least 31% downside to a fair value of $27.

The Script

• NILE has become a share loser.  The bulls have always argued that because of it’s price advantage (typically 30-40%) they would be able to steal sales away from their brick and mortar peers.  Initially this was true, from 2001-2007 they grew sales at a CAGR of 30.6%.  However, over the past three years their domestic business has grown 2.8%, below TIF/SIG and only slightly better than the laggard ZLC.
• After realizing they were heading in the wrong direction and firing the long time CEO (Q3 2011)they have come up with a revamped business plan that looks very risky.  Specifically:
  • They plan to cut price further to drive traffic.  If you are already priced so far below the competition how much elasticity will you get out of another 5%?  And the hit to margins is guaranteed.
  • Attempting to emphasize the non engagement business is a mistake.  Versus their bread and butter built to order engagement model it is more working capital intensive (FCF is a big hub of the bull thesis) and it introduces fashion risk .
  • Their 2012 guidance assumes success that hasn’t materialized yet, I see further risk to estimates
  • Valuation has always been crazy, but with the most recent cuts it seems ludicrous here.  How does a company that just posted a down revenue quarter and guided to a +1-3% Q1 (after missing 3 quarters in a row…) get 33x non-gaap EPS and 17x EBITDA?

Category killer?

The below table outlines NILE’s domestic results vs their traditional peers:

The model has lost the momentum it used to have.  Even on a three year basis NILE lags everyone except ZLC who were struggling due to a lack of third party financing.  Goldman Sachs even had a positive pre-quarter note out highlighting that the online jewelry category grew 21.5% in Q4 11, how did NILE manage to shrink?

Possible reasons for the disconnect:

• Competitors such as AMZN and ZLC have built up their offerings, ZLC has a similar do it yourself offering and AMZN has been expanding into the category
• Diamond pricing has been rising, this narrows their price gap, admittedly if diamond pricing falls this would be bad for the short (it’s interesting though because until this year mgmt always firmly stated that diamond pricing didn’t matter, now it is part of their defense)

The New Plan

Mgmt has outlined three areas they intend to focus on.

1. Getting more aggressive with price

• Pretty self explanatory, but how can they expect anything to change, their only real competitive advantage right now is price and the discount is already pretty deep.  It seems like the consumer would either be interested at a 30-40% discount or actually need to physically see the item before ordering
• The price cuts were implemented late in 2011/early 2012, as per Q1 guidance they have yet to work

2.Focusing on the non engagement business since it is higher margin and will drive customers who will be repeat purchasers (females vs. males who only buy one ring)

• This changes the cash flow story.  NILE’s engagement business works off virtual inventory, so the diamonds never really sit on the balance sheet.  This allows for a nice negative net working capital cycle, they collect the cash immediately and pay suppliers 90 days later.  With the non engage product they will have to buy the full form in advance and let it sit on the balance sheet.  They feel suppliers will give them 120 terms to make up some of the difference.  Inventories were up 45% in Q4 2011, some of that is likely due to softer than expected sales but I’m sure it is also them building their assortment of bracelets and other trinkets. 
• It also introduces fashion/assortment risk.  You can go on the website and check out the selection of bracelets, earnings, etc.  I’m definitely not the right person to judge this stuff, but a lot of it looks pretty cheap.  Because of the inventory dynamics mentioned above NILE hasn’t really had to liquidate any duds it may have bought, I see this as a big risk and mgmt has no real experience managing it.
• The street hasn’t discussed these aspects of the business, so either they are keeping it under their hat or they will be incrementally negatively surprised as they play out.

3.Spend more on the international business.

• This is definitely a good idea, and a key risk to the short thesis.  But it should be noted that after 9 years they have only grown it into a $60m business.

Guidance Risk

I believe there is still risk to guidance because, as noted above, the price cuts were implemented in late 2011/early 2012 and have yet to gain traction.  Full year guidance assumes +10-20% revenue growth with Q1 pegged at +1-5%, they are clearly baking in some solid acceleration.

Estimates

Cash      $89.4                                                     NI           $11.4

Debt      $0.7                                                        D&A       $3.4       

Cap        $583                                                       Capex   $4          

EV           $494.5                                                   2012 FCF = $10.8

Note:  The FCF would normally be higher as payables grow with topline and receivables stay static but I assume the inventory build for the non engage business offsets this going forward.

Valuation

The stock should get a premium to it’s tradition peers which trade at between 7-14x EPS but due to lackluster performance shouldn’t demand a high growth internet valuation.  I think 17.5x + $6/share in cash, or $27, is reasonable.  Although giving them credit for the cash is tricky because the payables support the balance sheet, if they were to liquidate tomorrow shareholders would only get $9m or so assuming they get cost on their inventory.

Risks

• They get bought, it isn’t a big ticket, although I see the barriers to entry in this business as non- existent
• It’s a cyclical business, if the economy takes off they will benefit
• Continued short squeeze

Conclusion                                                        

Blue Nile has turned into a share loser, it is no longer growing, they recently lost the CEO that helped start the company, their turnaround plans are risky to both the P&L and cash flow, and despite all this the stock trades as if the company was in hyper growth mode.  I believe the reason the opportunity exists here is a pure short squeeze along with some naïve sell side research.