Blue Nile's Real Sparkle


By Timothy J. Mullaney As shares of online jeweler Blue Nile (NILE) climbed 16% last week, Wall Street could have been forgiven for a succumbing to a touch of vertigo -- and cynicism. The well-publicized initial public offering (the Seattle-based company went public May 20) was sent into the markets amid admiring coverage in both BusinessWeek and Barron's. It went public at $20.50 a share and closed on its first day of trading at $28.40. On June 4 it briefly crossed $41, for a 100% gain in less than a month, before settling down to close at $39.27.

Dour prognosticators were quick to declare Blue Nile the new Ashford.com, Webvan, or Buy.com. Indeed, on June 7, the stock fell more than 8%, to close at $35.98. So, are the bears right or wrong?

A good case can be made that they're mostly wrong. What they ignore is that Blue Nile, which had $129 million in sales last year and made $11.3 million before a one-time tax gain, bears no resemblance to the profitless, almost sales-free dot-coms of yore. Comparisons to e-jeweler Ashford.com -- which went public in 1999 with sales of under $4 million per quarter before being sold twice for a pittance -- aren't valid. And the surge in Blue Nile's stock isn't about faith in a mighty empire that has yet to be built, as one could argue was the case with Amazon.

SOARING SALES. Indeed, a close examination suggests that the reason for the stock's surge is simple arbitrage: It was sold at the IPO as if it were a traditional jeweler, like Zale (ZLC), and the market has repriced it as a dot-com. The three investment banks that handled Blue Nile's IPO -- lead underwriter Merrill Lynch (MER), Bear Stearns, and Thomas Weisel -- have little presence among dot-coms, but lots of expertise covering offline retailers, including jewelers. What everyone is missing is that Blue Nile's business model is e-tailing at its best: Take advantage of lower operating expenses to pass savings onto consumers while still achieving above-par profits.

At the IPO price, Blue Nile was worth a lot for a jeweler -- but dirt for an e-tailer. At about $360 million market value, the $20.50 price worked out to 32 times last year's pretax profits. Amazon's (AMZN) valuation is about 80 times 2003 pro-forma profits. With a market cap now approaching $617 million, Blue Nile is a different proposition than it was at $360 million, but the current price is probably a better reflection of its real value. A look at the numbers explains why.

Blue Nile's sales jumped 89% last year, and they were up 46% in the first quarter of this year, vs. a year ago. In the first quarter, operating expenses -- including marketing -- were just 15% of sales, down from 17.5% a year ago. That crushes rival jewelers: At Zale, the largest U.S. jewelry chain, expenses chew up 38% of revenue -- up a point from last year. Blue Nile's low ratio of expenses to sales helps explain why pretax profits grew 76% in the quarter. Contrast that with Zale, which has had a turnaround of its own and saw profits grow 19%.

SEASONAL SURGES. Both Zale and upscale jeweler Tiffany (TIF) have sold off in recent months as investors have realized that e-tailers Blue Nile and Amazon, which rolled out a jewelry area in April, are credible players. Turns out your girl won't turn down a Web-bought diamond -- especially if you use your savings to buy a bigger one. On average, Blue Nile charges about 35% less for jewelry than offline competitors, yet its 2003 operating-profit margin of 9% is nearly double the industry average of 5%. It seems Blue Nile is worth a multiple larger than the 14 times earnings the market pays for bigger, but slower-growing, less-profitable Zale.

While there are few earnings estimates for Blue Nile -- no analysts have formally picked up coverage yet, and the federally mandated quiet period doesn't expire until June 15 -- those estimates that exist may be too low. Wall Street sources say Merrill told investors at Blue Nile's roadshow presentations that sales growth would slow to 25% this year, for a 2004 total of $162 million, and that earnings would be 47 cents a share. But with the first quarter's 46% growth and earnings per share (EPS) of 12 cents, 25% seems like a low-ball estimate. The jewelry business is seasonal, after all, and in 2003, only about 19% of Blue Nile's sales and 15% of its profits came in the first quarter.

Mark Mahaney, an analyst at American Technology Research who's boning up on Blue Nile in advance of beginning coverage, says EPS of 60 cents to 70 cents is more likely, and that could easily rise to $1 or more in 2005. He says of Merrill's estimate of 47 cents in 2004 and 65 cents in 2005: "They're sandbagging."

COMPARISON SHOPPING. If Blue Nile does see EPS of 65 cents this year, its stock is trading at 55 times this year's earnings and 36 times Mahaney's informal 2005 projection. (Indeed, if the first quarter provides the same 15% of yearly profits it did in 2003, that would put results for 2004 at 80 cents a share.) Those multiples are higher than for Zale or Tiffany, but less than Overstock.com (OSTK), the still-profitless Web clearance store whose market cap is greater than Blue Nile's. DVD-rental service Netflix (NFLX), which, like Overstock, went public in 2002, sells for about 64 times this year's estimated earnings.

Blue Nile is holding up -- so far -- under competition from Amazon. The one bear scenario that might give investors pause is that other Internet competitors will squeeze its prices and margins, just as Blue Nile is doing to offline jewelers. The biggest competitor is expected to be Amazon. But in the first quarter, Blue Nile's gross margin stayed at 22.9%, just above the 22.8% it posted for all of 2003. Amazon says its gross margins in jewelry will be a tiny 15%, with diamonds commanding a mere 13% margin.

Mahaney says he checked a list of 20 hot-selling items on Blue Nile and on Amazon and found the average was about 35% less at Amazon. But Mahaney's analysis has problems of its own. The gifts he cross-checked had an average price of less than $300 -- less than a third of Blue Nile's average sale. Most of Mahaney's sample were key chains and cheap bracelets, while most of Blue Nile's business is diamonds, especially engagement rings. On the one engagement ring in Mahaney's sample, Blue Nile was actually cheaper by $135, or 4.7%. So, the near-term pricing pressure on Blue Nile may be smaller than many market players think.

ANOTHER AMAZON? If Blue Nile can sustain its prices as competition from Amazon takes shape, or even make its gross margins decline gradually rather than suddenly, then the market's valuation of its stock is a whole lot smarter than that of the underwriters. It's no surprise that the stock has already begun to come off its recent highs, since 100% monthly gains are rarely sustainable.

Ironically, down the road, Blue Nile's financial profile could very well look a lot like a smaller version of Amazon, which has exploited growth to boost profits even as its gross margins slowly decline. The e-tailers, while competitors, may have more in common than a first glance would suggest. Remember, people were skeptical of Amazon, too. Mullaney is BusinessWeek's E-Business editor


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