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Monday, August 24, 2009

Bidding on BIDZ (Part Three/Final) - Detailed Long Thesis

BIDZ continued - this is the third and final part our analysis (written in July, but only published now, including a few current updates)

The Long Thesis - Why We Own BIDZ

Since our initial post on 8/10/09, shares of Bidz (BIDZ, $3.15) are off 35% compared to flat to slightly higher performance for the S&P 500, Blue Nile (NILE), and Amazon (AMZN):

The decline follows lower-than-expected results the same day (after market close on 8/10/09). We previously commented on results and the overall retail sector. While still profitable, revenue was down 51% Y/Y as jewelry remains non-essential and low on the priority list for many consumers. Further, we believe Bidz's business is even more discretionary than the business of Blue Nile and other jewelry retailers that are helped by less discretionary engagement ring sales.

Bidz is not alone in its pain. We are aware of several other discretionary/luxury retailers that suffered large Y/Y revenue declines in the June quarter: Sotheby's (BID) down 48%, Ethan Allen (ETH) down 41% Y/Y, and Nutrisystem (NTRI) down 32% Y/Y. We can even find meaningful Y/Y revenue declines outside of retail: Tyco Electronics (TEL) down 34% Y/Y and Freeport-McMoRan Copper and Gold (FCX) down 32% Y/Y.

We prefer to invest in companies trading a low multiples of earnings with current-year growth, yet sometimes venture outside of this requirement when we find what we believe to be a significant discount to the valuation that would be assigned to a business by an informed private market buyer.

In this case, despite limited short-term forecasting visibility, our BIDZ thesis is focused on the durability and strength of the business model, which we believe warrants a higher valuation and provides a margin of safety at present levels. We believe shares are attractive for following key reasons:

(1) Jewelry retailing is a good business over time.

Many well-known value investors own jewelry businesses with a long-term view:
  • Berkshire Hathaway (BRK-A, BRK-B) owns three jewelry companies: Ben Bridge Jeweler (acquired 2000), Borsheims Fine Jewelry (acquired 1989), Helzberg Diamonds (acquired 1995).
  • Berkshire Hathaway also owns the Richline Group (formed 2007), which is a manufacturer and importer of jewelry. Richline actually purchased some intellectual property and tools from Bidz in April that the latter acquired in a bankruptcy auction - link here.
  • Other value investors, such as Harris Associates, are big fans of Signet Jewelers, which owns Kays Jewelers, Jared, and other chains in the UK. Note: Signet reported June quarter same store sales down 5% Y/Y.
Why own such businesses? They are companies with established brands and scale that keep consumers coming back (frequency/relationships) and that generate excellent margins, earnings, and free cash flow on a normalized basis. Also, jewelry has a large addressable market (slide sourced via Bidz September 2008 management presentation):

(2) Difficult-to-replicate franchise with history of profitability and extremely high returns on invested capital
  • While no company can rest on its laurels, particularly in retail, we argue that barriers to entry are larger than some investors appreciate once an Internet franchise successfully carves out a specific niche and has scale - think Amazon (AMZN), Blue Nile (NILE), eBay (EBAY), Expedia (EXPE), PetMed Express (PETS), and Youbet.com (UBET). As we noted in our second PetMed Express post, there were and are plenty of me-too participants in the backyards of each player, but the spoils usually go to the number one player in a given market (on- and off-line). Moreover, achieving and sustaining profitability is not an easy task for many online players – see Overstock (OSTK) and Bluefly (BFLY), both of which have never been profitable on an annual basis.
  • Based on revenue, excess cash generation, Internet traffic (referenced in Part Two), brand recognition, and repeat business, we think Bidz is an established leader in online jewelry retailing.
  • Over the past five years, Bidz spent $43.2 million in sales & marketing to build the brand and, in 2008, acquired 262 thousand new customers (down 6% Y/Y) with an average acquisition cost of $48. The customer acquisition cost compares very favorably to an average selling price per order of $177 in 2008.
  • Bidz announced on 6/10/09 that the company ranked #2 in Internet Retailer's Online Jewelry Category (behind Blue Nile, based on sales) and #71 in Top 500 Guide of the largest e-retailers, an improvement from #74 in the 2008 guide and the fourth consecutive year that Bidz.com has been on the list.
  • In the last holiday season (4Q08), average orders per day were 2,462 (down 45% Y/Y) and average items sold per day decreased 35% Y/Y to 8,287, yet average items per order increased Y/Y to 3.4 from 2.9. For 2Q09 metrics, please see earlier post. Below, we include data through 2Q08:

  • Prior to the brunt of the economic decline last fall, management reported that an average customer transacts 3.5 times per year and had an average lifetime value of $1,109 (six times average order value).

  • Bidz operating margins in 2006, 2007, and 2008 were 4.2%, 11.2%, and 11.6%, respectively, while GAAP net income was $5.4 million, $18.1 million, and $14.4 million. While now dated, the below graph shows that Bidz operating margins were ahead of online peers through 2Q08 (*Blue Nile's 6.2% edged ahead of Bidz's 4.3% in 2Q09):
  • As with most retailers, the company needs to invest in working capital (inventory) when growing, so free cash flow (CFO less capex) was negative in 2006 and 2007, but a positive $17.6 million in 2008 as inventory declined with slower full-year top-line growth. Capital expenditure requirements are low at $1.0 to $1.5 million per year and the company has no debt.
  • The company is able to reinvest cash flows into the business and, last year, launched Spanish, Arabic, and German language sites. In 2008, approximately 1/4 of sales were international. We potential for international growth to offset US weakness and fuel future expansion so long as marketing/branding works.
  • The company turns net operating assets very quickly: approximately nine times in 2006, six times in 2007 and seven times in 2008. Multiply turns by after-tax operating margins of 3%, 8%, and 8%, respectively, and we have RNOA of 27%, 42%, and 54%. ROIC calculations are similar at 27%, 28%, and 48%.
  • Bidz announced on 7/22/09 that it was ranked number one in the Los Angeles Business Journal's annual list of the most profitable Los Angeles companies as of June 30, 2009, based on a three-year average return on equity of 88.2%. We note that the average is skewed downward (43% in 2008 versus 127% in 2006) because of higher working capital and shareholder equity.
Considering all of the above, we see a niche franchise that is well-placed for future growth and excess cash generation.

(3) Favorable long-term secular trends
  • People like to shop – while the average American consumer is struggling, we submit that Americans will always be consumers, with some arguably addicted to purchasing products from TV channels such as QVC.com and HSN.com, as well as Web sites like Bidz.com. A growing middle class elsewhere in the world also brings more consumers.
  • More commerce will gravitate online over time – although e-commerce growth is lagging amidst the recession, sales are holding up better than offline retail sales. comScore reported 1Q09 online sales flat Y/Y versus overall retail sales down 5% Y/Y.
  • Leading players like Bidz should gain more share for reasons highlighted above in point (2).
  • The below slide (from September 2008) provides perspective on traction for online jewelry sales (note: forecast is now altered, with negative growth at least for 2009):

(4) Shareholder-friendly management team

Despite some areas for improvement noted in the corporate governance section (in Part One), management is highly motivated to generate shareholder value given large insider ownership. Much of management ownership consists of stock options with an average exercise price of $6.20 (based on 6,864,500 options outstanding for entire company per proxy). We think management’s commitment is illustrated by its focus on profitability as well as the large share buyback program (noted previously). In addition, we believe the company’s high RNOA/ROIC demonstrates successful capital allocation.

(5) Attractive absolute and relative valuation on current earnings and on normalized earnings power
  • Shares of Bidz are trading at six times 2008 earnings and fifteen times our downward revised 2009E earnings of $5.0 million ($0.20 per share) from $8.0 million.
  • Although difficult to foresee improved top-line performance and/or multiple expansion in the near-term, we believe BIDZ could fairly trade at 15 to 20 times earnings (5% to 7% yield) given the company’s established, difficult-to-replicate, high-ROIC online franchise. Importantly, we believe an informed private market buyer would award a similar valuation.
  • In our initial post, we established a $5.25 - $7.00 (~$6.00 midpoint) fair value on depressed 2009E earnings, which no longer holds given reduced expectations for 2009. However, giving credit for a return to growth and normalized earnings of $12.0 million ($0.50 per share, still below 2007-08 levels) would imply $7.50 - $10.00 per share (~$9.00 midpoint).
  • On a relative basis, BIDZ is extremely inexpensive compared to Blue Nile (NILE), which trades at 77 times TTM earnings and 53 times consensus 2010E earnings. NILE trades at 42 times TTM EBITDA and 2.8 times sales, compared to 4.7 times and 0.5 times for BIDZ, respectively.
  • Blue Nile’s TTM reported operating income of $16 million and 5.6% margin compare to Bidz’s $14 million and 9.3% margin, respectively. On an earnings and free cash yield basis, NILE trades offers current investors only 1.3% and 2.9%, respectively, compared to BIDZ's 11.3% and 22.0%. On a TTM operating income to enterprise value yield basis, NILE's yield is 2.3% compared to BIDZ's 20.3%. We prefer to buy companies offering at least a 10% EBIT/EV and FCF yield.
  • Even acknowledging lower forward yields and strained American consumers, we find a great level of comfort in BIDZ high TTM earnings/FCF yields (which already include three quarters of intense economic contraction). Although we like Blue Nile's business model and established franchise -- in our view -- NILE's valuation is currently supported by the greater fool theory (with evermore speculative buyers necessary to push shares higher).
  • As mentioned earlier, we see Blue Nile’s business as less discretionary than that of Bidz, warranting at least some premium. However, we see no reason why the wide gap should persist over time, particularly if certain Bidz overhangs are removed. We expect NILE’s valuation multiple to compress while BIDZ’s multiple expands.
  • BIDZ also trades at a significant discount relative to Amazon and a number of other companies. We include two comp sheets below for BIDZ, the first smaller companies and the second larger (click to enlarge - price info as of 8/21/09):
Versus large-cap companies:

  • Finally, we have a recent comparable M&A transaction in the online retail space: Amazon’s purchase of Zappos. Amazon management relayed on the company’s earnings call that Zappos has approximately $635 million in 2008A sales with “a small profit”. Amazon’s cash/stock purchase price of $847 million implies a price to sales purchase multiple of 1.33 times. If we awarded the same multiple to Bidz, the implied share price would be $10.46, or 3.3 times current levels.

Our bet is that Bidz.com won’t forever remain a castaway. Despite all of "the hair" on top of macroeconomic concerns (discussed in Part Two), we see an excellent entry point into a high return on capital business with a growing global franchise. Sooner or later, we expect the market will focus on the sustainability and earnings power of the company’s business model, likely eliminating the margin of safety that exists for buyers today.

Happy investing,

Jeffrey Walkenhorst

Disclosure: Long BIDZ, BRK-B, EBAY, PETS, UBET.

© 2009 Jeffrey Walkenhorst
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