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Saturday, October 3, 2009

Things That Don't Make Sense: NILE's Valuation

We've previously written on Blue Nile (NILE, $59.57) in our Bidz.com (BIDZ, $3.14) series and in our May post, People are Still Getting Married.

We like Blue Nile's established online franchise, but pointed out the following in our 8/24/09 Bidz post:
  • 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 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.
Updated as of 10/2/09's close:
  • At 9 times TTM earnings and 10 times consensus 2010E earnings, BIDZ is extremely inexpensive compared to Blue Nile (NILE), which trades at 84 times TTM earnings and 59 times consensus 2010E earnings. NILE trades at 46 times TTM EBITDA and 3.1 times sales, compared to 5.8 times and 0.5 times for BIDZ, respectively.
  • TTM operating income and margin figures remain the same as above (through June). On a TTM earnings and free cash yield basis, NILE offers current investors only 1.2% and 2.6%, respectively, compared to BIDZ's 11.1% and 22.4% (for reference: TTM free cash flow generation for Bidz was $15.6 million compared to $22.8 million for Blue Nile). On a TTM operating income to enterprise value yield basis, NILE's yield is 2.0% compared to BIDZ's 20.5%.
Let's make the valuation disconnect even more clear. In one of our favorite investment reads, One Up On Wall Street, Peter Lynch plainly explains the price to earnings multiple as "the number of years it will take the company to earn back the amount of your initial investment--assuming, of course, that the company's earnings stay constant."

SO, with respect to NILE, we're looking at a whopping 59 years on a forward basis to recoup estimated 2010 earnings of $1.02 (consensus). Moreover, the forward estimate gives credit for an earnings recovery from recession-depressed $0.75 in 2008 and an estimated $0.81 in 2009 to the company's prior peak earnings level of $1.04 in 2007. By contrast, for BIDZ, an initial investment today will be earned back in only ten years, which makes Common Stock Sense to us.

What explains Blue Nile's astronomical valuation? At least a few possibilities: (1) economic recovery hopes, (2) short covering amidst small float (9/15/09 short interest of 3.1 million shares versus a 3/31/09 peak of 6.1 million shares), (3) momentum traders bidding higher because the stock "works", and (4) the greater fool theory, where speculative or possibly aloof "investors" purchase on the hope others will keep buying (similar to our #3 momentum traders) with the hope that the valuation will get even crazier. For example -- see irrational, short-lived jump to $100 in 2007:

Although anything can happen in the short-term and shares may move higher on momentum, we see the stock as trading on thin air given the rich valuation, seemingly high expectations, and sizable insider selling in the $40s-$50s. Blue Nile's CEO sold 138 thousand shares in June around $50, or approximately 27% of his position pre-transaction for total proceeds of approximately $6.7 million.

To be sure the valuation lacks fundamental support, let's quickly assess where the stock is trading with respect to future earnings power. We'll award credit for a return to relatively high growth (15% per year) and peak net margins of 5.5% in 2014 (year five). In this scenario, year five revenue is $579 million with net income of $32 million. If net income is discounted back to present (assume 12/31/09) at 10%, net income is only $20 million. Thus, today's market capitalization of $865 million is a rich 27 times the non-discounted result and 44 times the discounted figure. Our summary analysis is below (click to enlarge):

Source: Company reports, JW estimates.

Finally, putting on our former Sell-Side Equity Analyst hat, we would not be surprised to soon see rating downgrades, especially from Argus, Citigroup, or William Blair, all of which upgraded NILE to Buy from Hold in May-July in the mid-$30s to low $40s. Of course, pure "valuation" calls are often frowned upon by Market participants and require fortitude by the analyst (or portfolio manager) making the call. We're aware that many retail investors think the sector can "work" through year-end despite an already prodigious up move in recent months and fair to rich valuations across the sector (as in: keep holding, maybe buy more, then -- quick -- head for exits before everyone else in December or early 2010).

We know some long-time institutional holders of NILE own the company because of its strong, growing franchise (that could well be gobbled up at some point), yet we think valuation discipline is both prudent and necessary. Moreover, many other well-positioned cash generating companies are available for significantly lower multiples of earnings and free cash flow, including Bidz.com, Youbet.com (UBET, $2.08, prior post here), and American Oriental Bioengineering (AOB, $4.71, prior post here). With so much lower priced merchandise offered by the Market, why pay 44 times discounted 2014 earnings? This isn't Common Stock Sense.

Happy investing,

Jeffrey Walkenhorst

Disclosure: long BIDZ, AOB, UBET.

© 2009 Jeffrey Walkenhorst
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  1. Jeff,

    not knowing BIDZ but having done some work on NILE, I think the stock trades at a high multiple b/c it is easy for investors to see how they are going to take mkt share from traditional jewelers and continue to grow revenue.

    I definitely dont get why it has such a high multiple even though the ROE is high.

  2. Hi Mike,
    Fair point -- no question that NILE and other leading online players will take share and grow over time.... That said, per our analysis, growth seems to be more than factored in for NILE eve though some premium is justified given the strength of the company's business model.


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