Blue Nile 4Q 2006 Conference Call

As a follow-up to my prior article, I will comment on Blue Nile, Inc.'s (NILE) conference call.

Before getting into the heart of the conference call, I was surprised by the stock price action during the day where the price fell $2.66 to $38.60 for a loss of 6.45%. I did not understand why Blue Nile was taking such a beating in advance of the conference call and on heavier than average volume. Once I saw the press release, which came after the market closed, I was not surprised. Blue Nile slightly disappointed.

As an aside, you should read and review Blue Nile's conference call transcript, which is provided by SeekingAlpha.

In my prior article I wrote the following:

• Average Earnings Estimate (Current Quarter): $0.31;
• Average Earnings Estimate (Current Year): $0.73;
• Average Revenue Estimate (Current Quarter): $91.90M; and
• Average Revenue Estimate (Current Year): $252.71M.

Although not stated in the prior article, Yahoo provides the following information:

• Average Earnings Estimate (1Q:2007): $0.17;
• Average Earnings Estimate (FY:2007): $0.92;
• Average Revenue Estimate (1Q:2007): $63.2M.
• Average Revenue Estimate (FY:2007): $302.4M.

With the benefit of the conference call, I can update this data:

• Earnings (4Q:2006): $0.35;
• Earnings Guidance (1Q:2007): $0.14–$0.15;
• Earnings Guidance (FY:2007): $0.80–$0.85;
• Revenue (4Q:2006): $90.7M; and
• Revenue Guidance (1Q:2007): $61M–$63M.
• Revenue Guidance (FY:2007): $290M–$300M.

While Blue Nile exceeded 4Q earnings, it missed 4Q revenue and it guided lower than the average estimates. However, I think Blue Nile is low balling its forward estimates so that it can beat them. In 2004 the company increased its revenues by about 31%; 2005, 20%; and 2006, 24%. Using the 2007 revenue guidance of $290M–$300M, the company is assuming roughly a 15%–20% increase. This range is lower than the company's historical range. Thus, I believe the company is deliberately low balling its numbers so that it can beat them. It is better to underpromise and overdeliver than to do the opposite.

While listening to the conference call, I was generally pleased and impressed. There were no strong outstanding items that caused me to worry. Instead, my impression is that the business is continuing to do well and is getting stronger with time. I will highlight in point form a few interesting tidbits:

• Lead time was shorted by one day. For most diamonds, lead time is only 3 days; signature collection is only 2 days;
• The company had 40 transactions of $50,000 or more during the quarter;
• $3.2M was spent on share repurchase with $93.2M remaining in the share repurchase program;
• The company provided forward guidance for the first time (see above);
• The company is having a tremendous start to the first quarter and, if the progress continues, the margins might go back to prior levels (about 22% from 21.6); however, the company is watching carefully to see if its new pricing strategy will stick;
• Margins across the industry are generally coming down, which is largely attributable to Wal-Mart and Costco;
• There are no significant online threats at present; and
• Previously, the company had an 80–20 split between new and returning customers; returning customers now constitute over 20 percent of the sales dollars, which is indicative of effective marketing; strong selection and quality of merchandise, and, more importantly, customer satisfaction;

Looking forward, the key flags or signposts that I will be watching are sales growth, margins, new entrants, internal industry competition, free cash flow, and valuation. Do sales maintain at least a 20 percent growth rate for the next several years? I think it should, especially as Blue Nile is growing internationally in the U.K. and Canada. Margins, new entrants and internal industry competition are all interrelated. Can Blue Nile maintain or grow its current margins? Does it adopt the Amazon model where margins are very thin? Or can maintain its differentiation and grow its margin? Until there are other viable and strong online competitors, I think it can at least keep its current margin with upside potential. Free cash flow is growing faster than sales are. While that is good now, it cannot last indefinitely. Also the company is now paying cash taxes after having burned off its net operating losses. Free cash flow is a key metric in gauging the health and prosperity of the company. Valuation is always a concern. While many short sellers believe that the company is excessively valued, the challenge remains with the shorts. Now the company had its earnings conference call, what is the catalyst that will drive the stock lower? If we accept the fiscal year 2007 earnings guidance as given above, then the company is currently selling for a forward PE of about 45–48. The company is also growing 20 percent plus per year. And the company is busily buying back shares with a short ratio estimated to be in the low 20s. The PEG ratio might be a bit high, but as all short sellers will tell you, valuation alone is not a good reason to short a stock. The question remains, what is the catalyst that will drive the stock down?

What is in store for tomorrow Tuesday? How should the stock perform? If Blue Nile had not gone down 6.45% during the day, I would have said the stock would lose some altitude because the company did not blow away the numbers. The forward numbers might even seem a bit low. However, Blue Nile did go down substantially during the day. The stock was only down $0.10 in after hours trading. So now I am not so sure.

I intend to keep my position in Blue Nile. The company appears to be focused on performing the right actions to continue to grow the company. There does not appear to be any substantial storm clouds on the horizon. The forward guidance is, I believe, set too low given the company's historical growth.

As a matter of disclosure, I am long Blue Nile.