Will Blue Nile’s Shares Defy Common Sense?

Consider what may seem like a common sense question. Would you pay 30x ’09 earnings for shares in a company that faces the following headwinds: (1) revenues and profits are expected to decline 5% and 10%, respectively, in 2009; (2) traffic to the company’s website is down 40%+ YoY in the past few months and is unlikely to rebound in the near-term: (3) the model depends on sales of high ASP and discretionary items, both of which are negatively impacted by the worst economic slowdown since the Great Depression (according to our new president); (4) demand for the key product has stalled; (5) management has less flexibility to cut expenses further; (6) key competitors like Tiffany, Zales, and Finlay Enterprises have reported sharp sales declines; (7) comScore reported that online jewelry sales declined 28% YoY during the holidays; (8) credit card application approvals are down significantly due to tighter credit standards and your model depends, in part, on credit card approvals; (9) MasterCard reported that sales of luxury items including jewelry was down 34% YoY during the holidays; (10) in 2008, 1,140 jewelry businesses went out of business, more than half of which were retailers, according to the Jewelry Board of Trade; and (11) competition in your online segment is intensifying.

The answer is not straight forward and depends on whether you believe that the economy gets worse from here or improves. I am in the camp that we are in this downturn for the next two years and the economic situation is likely to get worse, not better, so my answer is obvious.

Since my write up on Blue Nile (NILE) in mid-January (Significant Macro Headwinds Could Drive Blue Nile's Shares Lower), in which I recommended shorting the shares, the stock has appreciated 15%, versus a 2% decline in the S&P 500. [The stock is the only down position in my portfolio.] I suggested that the stock price is properly valued at around $10, given the lack of earnings growth.

The shares at the time were trading at 23x ’09 GAAP EPS and at a PEG of 1.3x, but Street estimates have come down, suggesting that multiples have expanded beyond the 7 points implied by the 30x ’09 multiple, and the PEG of 1.7x that the shares are trading at today.

When NILE reports earnings on Wednesday Feb. 18, I will decide to cover my short because common sense failed or I missed something entirely from left field. Analysts are estimating sales of $91.5 million (down 20% YoY), operating income of $7.97 million (down 21% YoY) for an 8.7% operating margin , GAAP EPS of $0.33 (down 25% YoY) and Adj. EPS of $0.37 (down 23% YoY). My bet is that the company misses those reduced estimates and provides very cautionary comments for the year ahead.

The shares have already corrected 60% from its 52-week high and ~80% from all-time highs set in late 2007. Despite the correction, I am sticking with my $10 price target in my previous write-up, which I based on a 10x multiple to 2010 GAAP earnings of $1.00. But that’s a 12-month out price target. If I applied the 10x multiple to 2009 GAAP earnings of $0.93, I am looking at a share price today of $9.30. The key is in my multiple, which I think is appropriate for a company facing the headwinds I noted in the first paragraph. And this is a 10x multiple for a company whose earnings are not growing in 2009. Even if you are generous and apply a 15x multiple you are staring at a $15 price target, which is 35% below the current share price.

There are some positives to the business such a relatively unlevered balance sheet, the potential to gain market share given the spate of jewelry companies going out of business (similar to Amazon), a low inventory model, and strong supplier relationships.

Thus, I am not stating that the business model is broken or is structurally challenged, like it Internet brethren eBay (EBAY). What I am saying is that the shares are overvalued and should trade at multiples that reflect the company’s realities.

Currently, the top 10 institutional investors own a significant number of the shares, and are likely not selling. Further, over 40% of the shares are sold short and it is difficult to get more shares to short. Thus, there is very little selling pressure on the shares and could explain why it is trading at such a high multiple. On the flip side, the potential for a material short squeeze is real if they post stronger than expected results, which is a possibility given the recently reduced estimates.

Seventeen Sell Side analysts cover the stock, of which 7 have sell ratings, 5 have buy ratings, and the remainder has holds. The median price target is $24. Blue Nile has a share repurchase authorization in place, but like most companies, I doubt they are repurchasing shares - NILE had $27 million on the balance sheet at end 3Q08 or $1.80 per share.

So what am I missing that the market is getting? Not sure, but hopefully I find out on Wednesday evening when the company reports earnings. However, from where I stand, common sense has to apply.