Blue Nile: A Short Squeeze Setup

Blue Nile, Inc. (NILE) is an interesting stock to follow in part because of its heavy short interest. There are at least two good sources for looking up the number of shares that are short or the short ratio. One is Yahoo's site (Yahoo: NILE) and the other is Short Squeeze (Short Squeeze: NILE). Yahoo indicates a short ratio of 15.4 and Short Squeeze indicates a short ratio of 24.2. The short ratio is the number of days of average trading that would be required to cover all short sales. Thus, according to Yahoo, 15.2 days of average day trading would be required to cover all short sales. Short Squeeze indicates 24.2. I treat five days as a yellow caution, and ten days as a red light signaling not to short.

Compare Blue Nile with Amazon.com (AMZN), another internet retailer. According to Yahoo, Blue Nile has the following characteristics:

• Forward P/E (fye 01-Jan-08) 1: 41.35;
• PEG Ratio (5 yr expected): 2.54;
• Price/Sales (ttm): 2.56;
• Price/Book (mrq): 14.77;
• Enterprise Value/Revenue (ttm): 2.30; and
• Enterprise Value/EBITDA (ttm): 25.857.

Similarly, Amazon has the following characteristics:

• Forward P/E (fye 31-Dec-07) 1: 54.78;
• PEG Ratio (5 yr expected): 3.98;
• Price/Sales (ttm): 1.64;
• Price/Book (mrq): 81.13;
• Enterprise Value/Revenue (ttm): 1.61; and
• Enterprise Value/EBITDA (ttm): 23.85.

Looking at these two set of metrics, we note that NILE has a significantly lower forward P/E and lower PEG ratio, both of which are good. NILE also has a higher Price/Book ratio, but that makes sense given that is also a lower PEG ratio. In other words, investors are willing to pay a higher price for relatively faster growing companies. The same applies to the two Enterprise metrics as well.

If we use Amazon as a relative proxy, then so long as Blue Nile does not stink up the joint when it releases its financials on Monday, 12 February 2007, investors might enjoy a nice pop in the stock. The key is that Blue Nile is massively shorted. If Blue Nile continues to do well, then there is no reason for the stock price to plummet. While it might be overvalued on a fundamental basis—a forward PE of 41 is rich—the stock might continue to stay at its current price level or go higher. The shorts need to cover sometime. And if all the shorts head for the exit at the same time, that action could propel the stock higher. Remember, there are between 15 and 24 days worth of short covering. That is a lot.

Another more traditional retailer operating in the same space is Zale Corporation (ZLC). It operates traditional brick and mortar jewelry retail outlets. While it metrics are much more modest, you need to think of what happened to all those small bookstores when Amazon.com first appeared.

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