Over the past few months there have been some nascent signs of stabilization in consumer spending. For the most part we have avoided the entire consumer sector during the rebound in the market in the past three-months. It has been our view that consumer spending will remain considerably strained for several years. Following the sharp rally in consumer stocks over the past three-months we started to look around for short opportunities in the sector. For the past 10-days we have conducted diligence on the jewelry space, an area which we were certain would be ripe with short opportunities. As is often the case in the investment process, the results of our research surprised us – trends in the jewelry market are not nearly as bad as we initially thought.

The combination of our fundamental analysis of companies in the space, recent management commentary and feedback from our proprietary survey of independent jewelers lead us to believe there is money to be made by going long one or two names in the sector. However, we still remain concerned about the tenuous state of the consumer, so we are recommending a pair trade to hedge exposure to a sell-off in the group – Long: Signet Jewelers (SIG) and Short: Blue Nile (NILE). We want to make it clear that this pair trade recommendation is not exclusively based on the valuation disparity between the two companies, which is sizeable. We think each side of this pair trade has strong individual merits. Our thesis is based on the following:

• Our proprietary survey suggests that demand trends for jewelry in the US are not nearly as bad as you would think. A combination of recent commentary from SIG management and the results of our survey of over 40 independent jewelers helped alter our views on current consumer demand for jewelery. In its most recently reported quarter, SIG reported a fairly modest 2.9% decline in same store sales and indicated they had started to see signs of stability in sales trends surrounding major holiday events. Interestingly enough, over 40% of the jewelers we surveyed have witnessed flat or an increase in sales thus far in 2009. Clearly things are not as bad as we initially thought when we started to evaluate the space. Additional findings from our survey suggest that jewelery demand has started to recover.

• Sales have improved from first to second quarter. More than 54% of respondents indicated that sales have increased sequentially from the first quarter to the second quarter. Overall, 82% of respondents indicated that sales were flat or up during the second quarter as compared to the first quarter (click on chart for full image view).

Source: PAA Research

• Pricing pressure is not widespread. As we started our diligence on the space, we were certain we would hear many stories about cut-throat pricing policies and aggressive promotions due to the large number of bankruptcies and liquidations that have occurred among jewelers over the past 12-18 months. For now it appears that the pricing environment remains somewhat promotional, but stable (click on chart for full image view).

Source: PAA Research

• Jewelers are reasonably optimistic about sales for the remainder of 2009 and the holiday season. Approximately 55% of respondents indicated they expect sales to increase YOY for the remainder of 2009. For the critical holiday season, 80% of jewelers expect sales to be flat or up compared to 2008 (click on chart for full image view).

Source: PAA Research

• Store closures and tighter inventory management among small jewelers has dramatically improved the competitive landscape for SIG. According to National Jeweler, the number of retail locations operated by the top 50 jewelry retailers in the US declined by 13% in 2008. In addition, countless smaller jewelers have been shuttered due to the weak demand environment. More than 50% of jewelers we surveyed indicated that they have reduced inventory thus far in 2009. Less competition, reduced variety at the point of sale and less inventory in the channel should enable SIG to gain significant market share over the next several years.

• Blue Nile will increasingly face more sophisticated and widespread competition from traditional jewelers. Blue Nile has rapidly emerged over the past decade as the leading exclusively online retailer of jewelry. The company has differentiated itself by providing consumers with a superior web experience and offering a better price point. However, traditional jewelers such as Kay, Jared, and Zales have become more sophisticated in their online sales strategy. According to Compete.com, kay.com and zales.com now generate more than three times as much traffic as does bluenile.com. Perhaps more disconcerting for Blue Nile is that the websites for leading traditional jewelers have witnessed strong increases in traffic in recent months, while the number of unique visitors to bluenile.com actually declined 16% YOY in May. Approximately 50% of respondents to our survey now think online discount jewelry retailers will gain market share at a slower rate going forward. We think increased competition could significantly reduce revenue growth for Blue Nile over the next 3-5 years.

• A recently filed lawsuit could damage the Blue Nile brand. In the jewelry business, every single sale is about trust. There are few transactions we can think of where the relative knowledge about the product between the seller and buyer is as large as that for the purchase of a diamond or gemstone. In many respects, the consumer is not buying the stone, they’re buying the jeweler. Blue Nile has accomplished what few thought was possible – they created an entirely web-based jewelry brand that consumers trust even though the purchase process is even more opaque than that at a traditional jeweler. For Blue Nile, consumer trust is the single most important element of their success in our view. We have obtained a copy of a recently filed lawsuit (Diascience Corp. v. Blue Nile, Inc.) against Blue Nile which alleges the company failed to disclose “enhancements” made to the gemstones the company sells. We cannot speak to the veracity of the suit, but if the case continues and gains traction in the media it could do significant damage to the trust Blue Nile has built with consumers, which would seriously imperil the company’s business model.

• The downturn has proven that the “secular growth” justification for NILE’s valuation premium was a fallacy. Over the next two years, we think SIG will demonstrate similar FCF characteristics to NILE, which suggests the valuation gap between the two companies could narrow substantially. We have followed NILE since its IPO in 2004. The stock always has commanded a significant valuation premium, which we thought was due to the widespread belief that NILE would continue to gain market share and had a long runway of secular growth ahead of it (similar in spirit to the thesis on AMZN). The 19% YOY decline in revenues in the past two quarters has more or less destroyed that thesis. It appears that revenue trends for NILE are just as cyclical as that for traditional players in the jewelry market.

Let’s try a little exercise, which has worked well for us in the past. The table below compares revenue growth and profitability of two companies operating in the jewelry business. We’ll give you a hint, one is SIG and the other is NILE, can you guess which one is which? (click on table for full image view)

Source: PAA Research

It’s not very obvious, so we’ll give you the answer. Company A is SIG and Company B is NILE. So what remains as the reason for NILE’s enormous valuation premium? We can only point to the company’s superior working capital efficiency and inventory turnover, which has enabled the company to generate strong free cash flow and high returns on capital. When you layer in a few measures of working capital efficiency, balance sheet liquidity and return on equity it becomes clearer as to why NILE might command a valuation premium. (click on table for full image view)

Source: Company Reports, PAA Research

However, in an environment where square footage expansion is likely to be low and inventories tightly managed we anticipate SIG will able to convert as much as their net income into FCF as NILE does. Additionally, it appears SIG’s revenue trends are stabilizing more quickly than those for NILE. We see little reason for NILE to command the same valuation premium. At the very least it seems unlikely that NILE shares can continue to trade close to 50x FY1 consensus EPS while SIG shares trade at less than 10x our FY10 EPS estimate. (click on image for full image view)

Source: PAA Research, Yahoo Finance

Our target return for this pair trade is 20-25%. Overall, we think SIG shares could trade north of $28, while we see downside for NILE shares below $30, materially lower if the aforementioned lawsuit escalates.

As always, please act accordingly….

Please click on this link to read our full report on our pair trade recommendation – Long Signet Jewelers (SIG)/Short Blue Nile (NILE)