April 21, 2014
BLUE NILE (NASDAQ:NILE)
BUSINESS DESCRIPTION
Blue Nile (“NILE”) is a Seattle-based online retailer, specializing in customized diamond jewelry. The company
possesses the largest inventory of certified diamonds in the world and dominates the online engagement ring category
with over 50% market share. Unlike traditional brick and mortar jewelers, NILE’s exclusive supply relationships and
efficient cost structure enables the Company to pass its savings onto customers, charging 20-40% less than its
competition. With access to over 135,000 certified diamonds and dozens of settings, engagement ring customers can
create truly unique rings without the egregious markup.
NILE is a world class franchise whose current valuation disregards three key developments: improving
wedding band attachment rates, a burgeoning China business, and critical mass in network effects.
INVESTMENT SET-UP
Poor sentiment, short term anxiety, and high short interest provide an excellent setup for a bargain purchase of a
franchise business. With a P/E of 41x, ostensibly rich multiples repel “value” investors who often bypass opportunities
that are not headline cheap. Similarly, a recent slowdown in sales growth disheartens even the most optimistic “growth”
investors. Meanwhile, short sellers, whose interest comprise roughly 10.5% of current shares outstanding, assert that
NILE’s share price is simply too high. While the shorts do not doubt the long term viability of NILE’s business model,
their valuations are anchored on trailing results and near term expectations. Collectively, their apprehensions are
reaffirmed in their minds by NILE’s recent fourth quarter earnings miss and reduced guidance, which sent shares
tumbling 15% on February 6, 2014. Guided by our strongly held views of NILE’s long term intrinsic value and the
sustainability of its superior business model, we feel comfortable purchasing a quality business at the only time quality
goes on sale—when there is pervasive fear and uncertainty in the marketplace.
WHAT WE LIKE ABOUT NILE
NILE is the dominant online jewelry retailer, commanding over 50% of the online engagement ring market. The
company possesses favorable and improving economics and maintains a clear competitive advantage by providing
consumers with the best product offering at the lowest cost.
Competitive Advantage: Low Cost Provider
NILE’s competitive advantage is selling quality diamond jewelry at the most affordable price. It maintains this low-cost
advantage by operating an efficient costs structure and by passing these cost-savings to its customers. While competitors
invest in expensive store fronts, pay out commissions to sales associates, and purchase costly inventory, NILE does
none of these. The business generates $450 million in revenues from sales in over 40 countries out of three offices and
two fulfillment centers. NILE accomplishes this with less than 300 employees, including knowledgeable and friendly
associates—available 24/7 in six languages—who take no commission. Lastly, NILE has developed exclusive
relationships with over 100 suppliers, enabling it to manufacture jewelry on a just-in-time basis.
This last point is unique to NILE and deserves further exploration. By ordering polished diamonds on a just-in-time
basis, NILE forgoes tying up capital in purchasing and holding very expensive inventory. Because vendor payment
terms range from 30-120 days, while customer payments are typically received upon purchase, NILE also benefits from
negative working capital. Most importantly, NILE’s virtual inventory of over 135, 000 diamonds ensures that customers
are getting a vast selection of diamonds at the best possible price. This virtual inventory is essentially an online diamond
exchange, pitting one seller versus the other and allowing the laws of supply and demand to set the most efficient price.
Assuming all consumers are rational economic agents, vendors who sell comparable diamonds at a premium will have to
reduce prices in order to sell their goods (why would anyone spend x+1 if they could purchase the same exact diamond, as governed by
the “four C’s,” for x?). We can witness NILE’s low cost advantage in real-time below:
1
First, comparing NILE’s inventory to Zales’, NILE has a far greater selection. A search for a round 1-carat, ideally cut
(EX), colorless (D) diamond of internally flawless (IF) clarity returned one diamond on Zales’ website, which cost
$22,966. NILE on the other hand, returned 14 results with prices ranging from $16,085 to $23,513.
Second, because the 14 diamonds listed on NILE’s “exchange” are essentially the same, consumers will naturally
gravitate toward the most affordable option. After all, each and every one of these diamonds has been certified by the
GIA (Gemological Institute of America), and NILE does not sell any synthetics. As a result, suppliers will have to
match prices if they want to turn their inventory, resulting in more competitively priced diamonds for the consumer.
SUPERIOR PROFITABILITY AND CASH FLOW
Existence of a competitive advantage becomes more compelling when we look at the industry’s profitability.
40
Return on Capital
40
30
30
20
20
10
10
0
Return on Equity
0
2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
-10
2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
-10
NILE
TIF
ZLC
SIG
NILE
TIF
ZLC
SIG
Source: S&P Capital IQ. Calculations based on calendar year-end dates.
2
In nearly every year for the past decade, NILE has generated higher levels of return on capital and return on equity than
its publicly traded jewelry peers. NILE’s average return on capital and return on equity during this time period was
24.8% and 28.6%, compared to an average of 8.4% and 6.5% for the peer group, respectively.
NILE’s unique capital light business model also results in a highly cash generative business, producing cash flows that
are many multiples of its net income.
5.0x
FCF / Net Income
4.0x
3.0x
2.0x
1.0x
0.0x
-1.0x
2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
-2.0x
-3.0x
-4.0x
NILE
TIF
ZLC
SIG
Source: S&P Capital IQ. Calculations based on calendar year-end dates. FCF defined as operating cash flows less capex.
In the past decade, NILE has generated, on average, free cash flows of 2.2x its earnings compared to 0.5x for its peers.
These levels of returns and cash flows can only be realized with a business model like NILE’s, where only limited
amounts of capital are tied up in stores and inventory, and where a smaller level of employees can support the business.
With only 291 employees, NILE generated $1.55 million in sales per employee, compared to $0.38 million, $0.16 million,
and $0.23 million for Tiffany & Co., Zales, and Signet, respectively.
Strongest Competitive Position in Favorable Industry
NILE competes in an industry in which no substitutes exist. People will always get married, and proposals will always be
sealed with an engagement ring. In other words, unlike other retail industries, which are extremely vulnerable to fashion
risk, the engagement ring market will never face obsolescence.
Additionally, major consolidation in the jewelry industry has improved the competitive landscape for existing players.
According to industry data compiled by the Jewelers Board of Trade, 26,754 jewelry retailers operated in the US in 1999,
the year NILE was founded. That number has declined by nearly 20% to 21,646 retailers in 2013. During this same
period, the US population has grown by 13% according to US Census Bureau statistics. The largest retailers have
experienced similar consolidation. In the past decade, five of the top 10 largest national jewelry chains have either been
acquired or gone out of business1. Signet’s (February 2014) announced acquisition of Zales combines the two largest
brick and mortar jewelry retailers in in the United States and reaffirms this trend.
Furthermore, store closures, cost cutting, and consolidation on the part of the brick and mortar jewelers are defensive
moves. Winners in retail play offense—not defense. As a result, many retailers are expanding their online capabilities—
an offensive move—and mimicking the customization of NILE’s “Build Your Own” features. This is economics 101: the
existence of above average profitability will attract competition. While some economists-types may argue that this will
ultimately lead to declining economic profits for NILE, we see this as a validation of NILE’s competitive position.
Moreover, borrowing from management theories, organizational legitimacy leads to industry creation. In other words,
the growing presence of online jewelry will lend greater credibility to the online jewelry market and remove the
psychological barriers associated with expensive online purchases, creating a larger pie for all participants.
3
Best-in-Class Customer Service & Leading Resource for Diamond Ring Education
NILE has some of the best customer service of all retailers, with a Bizrate.com rating of 9.1 out of 10.0 and a Net
Promotion Score of over 80. NILE’s friendly and knowledgeable associates, who are available 24/7 in over six
languages, are critical to NILE’s success; an online jeweler without this capability is certainly doomed to failure. Unlike
other retailers, NILE’s associates are not commissioned and have no incentive to upsell potential clients, who can make
their purchases in a no-pressure environment. During my conversations with NILE’s jewelry consultants, I was advised
on several cost saving tips, such as purchasing a 0.98 carat diamond ring versus a 1.0 carat diamond—a size difference
undetected by the naked eye. Such incentives do not exist when commissions are at stake.
NILE also has industry leading diamond education resources. When searching the words “diamond education” on
Google, bluenile.com is the first result. Though I have no way of verifying this, I would argue that more people learn
about the “four C’s” from bluenile.com than from any other resource. Anecdotally, we spoke with several newlyweds
who were referred to bluenile.com by their independent jewelers for its high quality education resources.
Coveted Consumer Demographic
NILE holds retail’s most coveted consumer demographic: young, educated, and high income. Its primary consumer is
typically between the ages 25-34, has a bachelor’s or post-graduate degree, and earns over a six-figure salary. Retailers
explicitly target this demographic and devote their marketing dollars toward retaining these high lifetime value
customers2. While Zales and Tiffany & Co. sell across the demographic spectrum, NILE focuses on this particular
consumer and is better positioned to benefit from recurring sales. NILE’s 25 year old consumer, pleased with his initial
engagement ring purchase, will likely turn to NILE for future jewelry purchases during his next half century of expected
life.
WHAT THE MARKET IS MISSING
The market is missing three key developments that are not reflected in the current share price: improvement in wedding
band attachment rates, hidden value in the China franchise, and critical mass in network effects.
Wedding Band Attachment Rate
The largest barrier for NILE’s engagement ring customer is making such an emotion and valuable purchase without
seeing the merchandise in person. However, once this barrier is crossed, converting this customer to a complementary
Blue Nile wedding band is significantly more likely. As a result, NILE is focused on capturing this wedding band
opportunity, a $4 billion market that carries margins double that of engagement rings, in what is a low risk, high return
strategy for the business. By targeting marketing investments and developing the “band matcher” concept, which
suggests two to five bands for every engagement transaction, NILE will leverage its core engagement customer to drive
wedding band sales.
NILE’s current attachment rates, the rates at which customers purchase wedding bands from the same engagement ring
retailer, is roughly 35%—slightly more than half the industry average of 63%3. Despite NILE’s focus on this product,
the market ascribes no value to improving wedding bands attachment rates.
The tables below illustrate our estimate of NILE’s current EPS contribution from its wedding band business at varying
attachment rates.
4
2013 Wedding Band EPS Contribution
Attachment
EPS
Incremental
EPS
Rate
Contribution
EPS
Accretion
35.0%
$0.25
$0.00
40.0%
$0.30
$0.05
6.0%
45.0%
$0.35
$0.10
12.0%
50.0%
$0.40
$0.15
17.9%
55.0%
$0.45
$0.20
23.9%
60.0%
$0.50
$0.25
29.9%
65.0%
$0.55
$0.31
35.9%
70.0%
$0.60
$0.36
41.9%
75.0%
$0.66
$0.41
47.9%
80.0%
$0.71
$0.46
53.8%
2013
EPS
$0.85
2016E Wedding Band
2013 Wedding
EPS Contribution
Band EBITDA
Attachment
EPS
Incremental
EPS
2016E
Rate
Contribution
EPS
Accretion
EPS
35.0%
$0.37
$0.00
$1.37
40.0%
$0.44
$0.07
5.0%
45.0%
$0.50
$0.14
9.9%
50.0%
$0.57
$0.20
14.9%
55.0%
$0.64
$0.27
19.8%
60.0%
$0.71
$0.34
24.8%
65.0%
$0.78
$0.41
29.7%
70.0%
$0.84
$0.47
34.7%
75.0%
$0.91
$0.54
39.6%
80.0%
$0.98
$0.61
44.6%
Source: SEC Filings, NILE Management Comments, Medina Singh Analysis
In 2013, we estimate wedding band earnings contributed $0.25 per share. Looking beyond 2013, the consensus forecasts
no improvement in wedding band attachment rates. Assuming NILE’s engagement segment grows to $420 million by
2016—which is consistent with the consensus top-line CAGR of ~10%—and attachment rates reach industry average
levels of 60%, EPS contribution from wedding bands alone would be $0.71 per share.
At $1.37, the consensus EPS disregards any possibility of improving attachment rates and neglects the traction this
product segment has recently achieved. At an investor conference in March 2014, CFO David Binder confirmed that
growth in wedding bands sales were the fastest among all product categories. With increased product awareness,
marketing investment, and by introducing features such as the “band matcher,” there is no reason NILE’s core
customer—the young, educated, wealthy male (who is already a happy customer)—would not purchase a complementary
wedding band at rates similar to the industry average.
China Opportunity
The value of NILE’s China business, which is currently producing ~$30 million in sales compared to nearly zero in sales
three years ago, is underestimated by the Street and is not reflected in the current stock price. For illustrative purposes,
the following table lists valuations for other high growth Chinese companies:
Chinese
Market Enterprise EV / TTM EV / '16 EV / TTM EV / 14'
Companies
Cap
Value
Revenue Revenue EBITDA EBITDA
DANG
1,029
829
0.8x
0.4x
NM
54.3x
VIPS
8,376
7,655
4.5x
1.2x
131.2x
48.0x
BIDU
54,587
51,526
9.8x
3.8x
22.5x
21.7x
SINA
3,775
3,191
4.8x
2.5x
51.6x
24.6x
NTES
9,243
6,256
4.1x
2.8x
8.4x
7.3x
SOHU
2,371
1,919
1.4x
0.8x
6.1x
NM
RENN
1,284
335
2.1x
1.9x
NM
NM
CTRP
7,066
6,382
7.2x
3.4x
38.2x
38.7x
MMYT
944
878
3.5x
NM
187.4x
LONG
580
278
1.7x
0.9x
NM
NM
Median
3,073
2,555
3.8x
1.9x
30.3x
38.7x
Average
8,925
7,925
4.0x
2.0x
43.0x
54.6x
Source: S&P Capital IQ
3 Yr
CAGR
40.5
273.4
59.2
18.2
18.6
31.7
27.0
23.2
29.7
28.0
28.8
55.0
Based on relative valuation metrics, growth rates, and the legitimacy of the company, NILE’s China segment should be
worth at least the median multiple of 3.8x revenue, or $114 million, which is more than a third of NILE’s current
enterprise value. If NILE were to reach its stated goal of $100 million in sales by 2016 (~49% CAGR 2013-2016),
NILE’s China segment would be worth $190 million using similar analyses, resulting in a valuation more than half of
NILE’s entire current enterprise value. Additionally, one could argue that NILE’s China business should be valued at a
5
premium to its Chinese counterparts, which lack an American brand name and whose financial statements are perceived
as less reliable. Viewed from a different lens, if NILE China was a standalone entity and was IPO’d today, there is no
scenario in which its equity gets less than a $100 million valuation.
IMAX recently sold a 20% stake in its China business, which grew sales 26% year-over-year, for $80 million, or a 7.1x
sales multiple. While this business is different from NILE’s, we can begin to understand what investors are willing to
pay for opportunities in China. NILE, which only entered Mainland China in 2011, grew its business to ~$30 million in
2013. If the company were to reach its goal of $100 million in sales by 2016, which implies a ~49% CAGR, it would not
be inconceivable for NILE to command similar valuations.
Below is a more detailed analysis of the why China is the most attractive new market for NILE and why NILE is best
positioned to capitalize:
China’s Tremendous Engagement Market
Over 13 million marriages occur in China each year. This is nearly six times the annual number of marriages that occur
in the US. Naturally, this makes China’s addressable engagement ring market much larger as well. According to NILE,
China’s engagement ring market is roughly $8 billion compared to $5 billion in the US. Chow Tai Fook, China’s largest
jewelry retailer, says the nation’s addressable market is $10-$20 billion4. Even attaining a sliver of this colossal pie would
be a major impact to NILE’s earnings power.
This opportunity is not available to all of NILE’s competitors—nor is it a priority for them—giving NILE an important
first-mover advantage. NILE has been in China for over three years now, starting with joining the Shanghai Diamond
Exchange in early 2011. Since then, NILE has built both simplified and traditional Chinese language websites, acquired
local distribution and fulfilment capabilities, and has hired local employees who truly understand China’s numerous
languages, varied customs, and jewelry culture. NILE’s most significant milestone was achieved earlier this year when
the Company acquired a license to sell jewelry direct-to-consumer as opposed to through a third-party.
James Allen, NILE’s closest competitor, currently has no business in China. Similarly, Brilliant Earth, another online
competitor, offers shipping to China, but this is as far as its reach goes. Neither of these players have Chinese websites,
Chinese-speaking associates, nor local distribution and fulfillment capabilities, which cannot be built overnight.
Compared with traditional, brick and mortar jewelry retailers, NILE is able to leverage its current, global supply chain
infrastructure and does not need to invest in physical store fronts to achieve sales growth. Moreover, NILE already
possesses the largest, exclusive inventory of GIA certified diamonds in the world. Having recently acquired licenses to
sell directly in China, NILE is now able to offer Chinese consumers access to the same exclusive global diamond supply
and transparent pricing we have in the States. A quick search through NILE’s US and Chinese websites confirms this:
Source: bluenile.com; bluenile.com/cn
On 3/31/2013: USD 5,630 = RMB 35,003
6
According to a Bain & Company research on Chinese e-commerce, more than 70% of survey respondents say they
price-compare before finalizing a purchase5. The same research also states the overwhelming concern of the Chinese
consumer is being sold fake products. In other words, the Chinese—like everyone else—appreciate quality at fair price.
Equipped with a direct-to-consumer sales license, NILE is now capable of offering access to over 135,000 diamonds—
all of which are certified (NILE does not sell synthetics, either)—in its virtual inventory to these consumers and will benefit
from continued growth in the region.
Sales
120
Forecast
400
376.8
100
350
80
300
60
250
~30
200
40
20
150
Estimated China Sales ($Mil)
United States Sales ($Mil)
450
0
2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
US Actual
China Estimated
Source: SEC Filings, NILE Management Comments, Medina Singh Analysis
Growing Diamond Market in China
China is the fastest growing diamond market in the world, where diamond retail jewelry sales increased at a 27% CAGR
from 2006 to 2012. This compares with a 4% decline in the United States, a 5% decline in Europe, and a 9% decline in
Japan during the same period6.
Source: Bain & Company Global Diamond Report 2013
While gold remains the most important jewelry category in China, diamond jewelry is the fastest growing. This growth
stems primarily from China’s burgeoning middle class, who purchase diamond jewelry to communicate their
achievements and status. As the Chinese middle-class continues to expand, and as Chinese millennials increasingly
adopt western wedding practices, diamond jewelry purchases will continue to grow. According to Bain & Company’s
7
Global Diamond Report 2013, China is expected to account for approximated a third of the global diamond demand by
2023.
Chinese E-Commerce
China has the world’s largest online population, with nearly 600 million internet and 500 million mobile internet users—
nearly twice that of the entire US population 7. As a result, China also has the world’s largest e-commerce market, with
over $300 billion in transactions in 2013. To put the size of China’s internet retail market in perspective, sales on
China’s “Singles Day” reached $5.7 billion—that’s nearly 2.5 times the sales generated on US’s Cyber Monday8. By
2020, China’s e-commerce market is expected to be larger than that of the US, Japan, Britain, Germany, and France—
combined9.
Source: KMPG
The confluence of China’s growing diamond market and China’s enormous e-tailing market provides an ideal dynamic
for NILE’s international expansion. With a growing middle class and internet penetration at only 44%, NILE will enjoy
long-term favorable economics from China. This opportunity is not ascribed value at the current share price.
Network Effects
Engagement rings are driven by referrals. The consumer who is about to spend thousands of dollars on a ring is likely
to consult his married friends and draw from their ring-buying experiences before finalizing his purchase. According to
NILE, two-thirds of engagement ring customers make their purchases this way. With a Net Promoter Score*1of over
80—and product returns at nearly 0%—NILE’s satisfied customer base is the ideal platform for referral business (Net
Promoter Scores for other respected retail names: Costco - 82, Apple Laptops - 72, Amazon - 64)10.
At over 360,000 engagement rings sold, NILE’s has reached critical mass in its consumer base where an increasing level
of referrals will lead to positive network effects. While there is no accurate way to measure this effect on NILE’s
profitability, consider the following example: assume that for every 10,000 couples who purchase an engagement ring, a
thousand couples successfully convert one friend, resulting in a new referral base of 11,000. While this incremental
consumption is small at low base levels, it becomes increasingly large as the referral base grows.
*
The Net Promoter Score is based on how likely a customer would recommend a product to a friend or colleague. The Score represents the
percentage of Promoters, those who respond with scores of 9 & 10 and are most likely to refer the product, less the percentage of Detractors, those
who respond with scores between 0-6 and are likely to spread negative word-of-mouth.
8
30
20
10
0
10
12
15
18
21
26
31
38
46
56
67
81
98
119
144
174
211
255
309
374
Potential Customers (1,000s)
Network Effects
40
Referral Base (1,000s)
At the same 10% conversion rate, NILE’s current referral base can lead to over 36,000 additional customers. At an
average engagement ring price of $6,000, that is $216 million in potential sales. This dynamic becomes even more
powerful when considering the potential lifetime value of this growing customer base (Valentine’s, anniversaries, birthday
gifts from the groom and fashion jewelry purchases from the bride).
This network effect goes beyond traditional word-of-mouth into social networking sites such as Pinterest, where NILE
is the most followed, liked, and pinned jeweler.
Source: Pinterest
NILE’s ~62,000 followers not only increase the company’s brand recognition, they also create the ideal platform for
additional business. One study suggests that Pinterest accounts for 23% of social-mediated e-commerce11. This is
second to only Facebook, which—at 1.23 billion accounts—has 18x the user base12. When combined with overseas
growth and consolidation in the jewelry industry, these dynamics create powerful effects simultaneously working in
NILE’s favor.
VALUATION
Sum of the Parts
Our sum of the parts analysis reflects the purchase price we would pay today to acquire the business in three distinct
parts:
1) Blue Nile ex China
2) Wedding Bands at Industry Average Attachment Rates
3) Blue Nile China
9
Part 1
We apply EBITDA multiples based off competitors listed in NILE’s 10-K to its non-Chinese business. Based on our
analysis and management’s comments, NILE’s China sales in 2013 were ~$30 million, or 7% of total sales. Assuming
NILE China contributed 15% of total EBITDA—more than double its proportion of sales—the remaining 85%
attributed to NILE ex China amounts to $14.8 million
Blue Nile ex China
Peer Multiples
Enterprise Value
Low
12.0x
178.0
Median
15.0x
222.5
High
TTM EBITDA
18.0x
14.8
267.0
Less:
Investments
Debt
Cash
(4.3)
0.6
(115.9)
Implied Market Cap
NILE ex China
Low
297.6
Median
342.1
High
386.6
Per Share
NILE ex China
Low
$23.48
Median
$26.99
High
$30.50
Applying peer multiples, ranging from 12-18x, to depressed TTM EBITDA of $14.8 million results in a valuation range
of ~$23.50-30.50 per share. While we believe NILE, which maintains a sustainable competitive advantage and is
growing faster than its peers, deserves a premium valuation, we are comfortable using this 12-18x range for the sake of
conservatism.
Moreover, these multiples appear more conservative when compared to a list of precedent transactions, where targets
were acquired for a median multiple of 22.7x:
Target
GSI Commerce
Drugstore.com
Fanatics
Internet Brands
Net a Porter
Rue La La
Zappos
Harry Winston
Median
Average
Buyer
Ebay
Walgreens
Ebay
Hellman
Richemont
GSI Commerce
Amazon
Swatch
Date
3/28/2011
3/24/2011
2/9/2011
9/20/2010
4/1/2010
10/27/2009
7/22/2009
1/14/2003
Price
1,908.6
396.9
277.0
537.3
350.0
350.0
885.0
1,000.0
Sales
EBITDA
1.4x
20.4x
0.9x
79.6x
1.5x
11.6x
5.0x
13.3x
6.4x
50.4x
1.5x
23.3x
1.4x
25.8x
2.3x
22.0x
1.5x
22.7x
2.5x
30.8x
*Net a Porter transaction in pounds
Part 2
For the wedding band business, we believe NILE can achieve the industry standard of 60% attachment rates by 2016—
up from the current rate of ~35%. In quantifying this, we make the following assumptions:
1) Engagement Sales Grow to $420 Million in 2016
This figure is in line with the consensus top line CAGR of ~10%, which we believe is conservative given the
dynamics discussed in the sections above.
2) Wedding Bands Costs 35% of Engagement Ring
10
NILE does not explicitly break out wedding band revenues, but we assume the typical set of wedding bands costs
on average 35% of an engagement ring, which is consistent with management’s comments and corroborates our
independent analysis based on tracking purchases on bluenile.com. This results in potential wedding band sales
of $147 million.
3) Wedding Band Gross Margins of 28%
NILE does not explicitly break out wedding band revenues, but management has repeatedly cited that the
segment generates twice the gross margins of the engagement business, which has historically been over 15%.
For wedding bands, we assume slightly less than double this amount at 28% gross margin.
4) Wedding Band Attachment Rates at 60% & Incremental SG&A of 10%
At a 60% attachment rate and incremental SG&A of 10%, this implies $88.2 million in total wedding band sales,
$13.8 million in total operating income, and $6.6 million in incremental operating income. Giving no D&A
benefit, we assume incremental EBITDA of $6.6 million also.
Incremental Wedding Bands @ 60% Attachment Rates in 2016
16E Incremental
Low
Median
High
EBITDA
Peer Multiples
8.0x
10.0x
12.0x
6.6
Market Value
52.9
66.2
79.4
Share Price
Wedding Bands
Low
$4.18
Median
$5.22
High
$6.26
Applying 2016 EBITDA multiples similar to the analysis in part one, we believe the incremental wedding band business
is worth ~$4.20-6.30 per share. While we could have used EBIT multiples, we use smaller EBITDA multiples for a
more conservative valuation.
Part 3
For Blue Nile China, we applied a range of sales multiples based on high growth Chinese companies. Given the size of
the China opportunity—which we detailed above—we are confident that NILE will reach its targeted goal of $100
million in China sales. To recap, our China thesis boils down to these four points:
1) China is the world’s fastest growing diamond market
2)China is the world’s largest e-tailing market
3)NILE has a Chinese website, Chinese employees, and Chinese fulfillment and distribution capabilities
4)NILE recently acquired a direct-to-consumer sales license in China earlier this year. If NILE can earn
~$30 million in China without this license, it will likely earn much more with this license.
Blue Nile China
Peer Multiples
Market Value
Low
1.6x
160.0
Median
2.0x
200.0
High
2.4x
240.0
Share Price
Blue Nile China
Low
$12.62
Median
$15.78
High
$18.94
16E Sales
100.0
Applying 2016 sales multiples to $100 million results in a range of ~$12.60-18.90 per share.
11
Sum of the Parts
Summing these three components results in a price range of ~$40.30-55.70 per share.
Sum of the Parts
1) Blue Nile ex China
2) Wedding Bands
3) Blue Nile China
Low
$23.48
$4.18
$12.62
$40.28
Median
$26.99
$5.22
$15.78
$47.99
High
$30.50
$6.26
$18.94
$55.70
Upside (Downside)
14.9%
36.9%
58.9%
At $40.30, the low end of our valuation range implies a ~15% upside from current prices (NILE 4/17/2013 close:
35.06). As a reminder, our analysis makes no additional growth assumptions for NILE ex China and is valued solely by
applying current peer multiples to a depressed trailing EBITDA figure. Furthermore, the Nile ex China business valued
in part one assumes no increase in attachment rates. To this we add a separate valuation for incremental increases in
attachment rates, which encompasses part two. Lastly, part three values NILE’s China opportunity, which currently
comprises less than 10% of sales. Based on the conservative assumptions used in our valuation, a 15% upside from the
low end of our valuation estimate provides an adequate margin of safety to warrant an investment in NILE.
NILE has several other initiatives that could create significant value such as their fashion jewelry business, designer
series (Monique Lhuillier), and Nordstrom partnership. Furthermore, NILE has been a significant buyer of its own
stock, reducing its share count by nearly a third since its 2004 IPO with an additional $40m earmarked for 2014.
RISKS Disappointing Near Term Results
NILE’s growth initiatives may take longer than expected before contributing to the firm’s earnings. As a result, near
term results may continue to disappoint. However, we are guided by NILE’s long term fundamental outlook and feel
that short term volatility in business results—and share prices—provide greater opportunities for the patient investor.
Mobile Conversion
NILE was the first online jeweler to launch a mobile app in early 2010. Since then, NILE has introduced many
enhanced features on its mobile platform, including “Build Your Own” as well as a shared shopping cart, which delivers
a seamless user experience between mobile, tablet, and PC. While mobile traffic has grown to 50%, conversion rates
remain below PC levels, resulting in less than 20% of revenues from mobile. Engagement rings customers will likely
continue to finalize purchases through PCs, given the high ticket prices. However, the mobile customer, who is
browsing through fashion jewelry and more prone to spur-of-the-moment purchases, will be a key driver of higher
margin Non-Engagement revenues.
Rapidly Rising Diamond Prices
Since NILE purchases diamonds on a real time basis, a rising price environment harms NILE’s value proposition.
When diamond prices rise, traditional retailers, whose inventories maintain lower cost bases, will be able to generate
profits without having to further increase prices. NILE on the other hand, will have no choice but to apply its margins
off an inflated raw-material cost basis. While an abrupt 20-40% rise—the average cost-savings NILE offers—in
diamond prices is unlikely, such an event will likely transfer market share to the brick and mortar competitors.
12
CONTACT US:
Kristofer Medina
Portfolio Manager
kris@medinasingh.com
John Choi
Analyst
jchoi@medinasingh.com
Proprietary Rights Notice: By accepting a copy of this letter, you acknowledge and agree as follows: This report is
provided to affiliates of Medina Singh Partners only for your personal, noncommercial use. Except as expressly
authorized by Medina Singh Partners you may not copy, reproduce, transmit, sell, display, distribute, publish,
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Partners. You also agree not to use the information provided in this report for any unlawful purpose.
13
Summary of Your Fund Terms
Subscriptions
Monthly
Minimum Investment
$250,000 (may be waived by GP)
Lock-up Period
1 year
Management Fee
2%
Incentive Fee
20% of net profit, subject to a high water mark
Investment Manager
Medina Singh Investment Partners LLC
General Partners
Kristofer L. Medina
Jaiveer Singh
Fund Auditor
Spicer Jefferies LLP
Prime Broker
JP Morgan
Introducing Broker
Wells Fargo Prime Services
Fund Administrator
Perennial Fund Services, LLC
Law Firm
Paul, Hastings, Janofsky & Walker LLP
Contact Information
Telephone: (310) 979-6900
Email: investor@medinasingh.com
14
REFERENCES
1Bates, Rob. "The Extent of the Industry's Shrinkage Is Demonstrated by This Chart." JCK Magazine.
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2Kumar,
3Cave,
V. "Customer Lifetime Value." N.p.: University of Connecticut.
<http://www.terry.uga.edu/~rgrover/chapter_29.pdf>
Laura. “Bridal Jewelry: More Customer, More Sales.” Retail Jewelers Organization Show 2013.
Phoenix Convention Center, Phoenix, AR. 29 January 2013. Presentation.
<http://theknotb2b.files.wordpress.com/2013/01/rjo-2013-more-customers-more-sales.pdf>
4Wong,
Kent. "Chow Tai Fook: The Inside Story." Interview by Martin Rapaport. Rapaport May 2012: n.
pag. Web. <http://www.diamonds.net/Magazine/Article.aspx?ArticleID=39992&RDRIssueID=
90>.
5Hoffmann,
Cave. Lannes, Bruno. “China’s E-Commerce Prize.” Bain & Company, 2013.
<http://www.bain.com/Images/BAIN_BRIEF_Chinas_e-commerce_prize.pdf>
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<http://www.bain.com/Images/BAIN_REPORT_The_global_diamond_report_2013.pdf>
7Hong,
8Barr,
Kaylene. "China’s Internet Population Hit 618 Million at the End of 2013, with 81% Connecting via
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9“Ecommerce
in China: Driving a New Consumer Culture.” KPMG, January 2014.
<http://www.kpmg.com/CN/en/IssuesAndInsights/ArticlesPublications/Newsletters/China360/Documents/China-360-Issue15-201401-E-commerce-in-China.pdf>
10"USAA,
Kaiser Permanente, Amazon.com, Pandora, Costco, Wegmans, Apple, TracFone, Southwest and
Westin Among the Highest in Customer Loyalty in the 2014 Satmetrix® Net Promoter® Benchmarks." USAA,
Kaiser Permanente, Amazon.com, Pandora, Costco, Wegmans, Apple, TracFone, Southwest And...PR
Newswire, 5 Mar. 2014. Web. <http://www.prnewswire.com/news-releases/usaa-kaiser-permanenteamazoncom-pandora-costco-wegmans-apple-tracfone-southwest-and-westin-among-the-highest-in-customerloyalty-in-the-2014-satmetrix-net-promoter-benchmarks-248541161.html>
11Smith,
Cooper. "Pinterest Is Powering A Huge Amount Of Social Commerce, And Twitter Isn't Too
Shabby Either." Business Insider. Business Insider, Inc, 04 Sept. 2013. Web.
<http://www.businessinsider.com/twitter-and-pinterest-in-social-commerce-2013-9>
12Smith,
Craig. "By the Numbers: 59 Amazing Pinterest Stats.” Digital Marketing Ramblings." DMR. 04 March
2014. Web. <http://expandedramblings.com/index.php/pinterest-stats/#.U0Q4SvldV-4>
15