NILE shares have rallied 17.9% in the past 5-trading days following a series of analyst upgrades from William Blair and Company and CitigroupInvestment Research. We wanted to spend a few moments to take a closer look at the Citigroup upgrade, which single handedly drove an 11.6% increase in the price of NILE shares. Overall, the thesis behind the upgrade does not appear to be “game changing” by any stretch and we still find our pair trade – long SIG/short NILE to be very compelling. Thus far the pair trade has returned 5.5% and we continue to target a 20-25% total return for this pair trade. Here are the key points to Citi’s NILE upgrade:

1. “Recent 25% Correction Provides Attractive Valuation Entry Point“. This is arguably the most laughable argument made in the entire research report. NILE trades at 44x consensus EPS estimates for 2010, compared to an average of 47x historically. On Citi’s 2010 EPS estimate the stock trades at a slightly more attractive 35x (and we emphasize slightly). In our original post on SIG and NILE, we argued that the economic downturn has proven that the secular growth justification for NILE’s valuation premium was a fallacy. The “bloom is off the rose”. NILE has witnessed similar cyclicality in its revenues relative to traditional jewelers. We accept that NILE deserves a premium valuation to other publicly traded jewelers, but not 100-200%.
2. “Q2 Outlook Appears Reasonable and Fundamentals Improving”. Our thesis is not predicated on a revenue or EPS miss for NILE, although the web traffic trends for the second quarter imply that a topline miss is a possiblity. According to ComScore, the number of unique visitors to bluenile.com declined 30% YOY during the second quarter. In order to achieve Citi’s 2Q09 revenue estimate, NILE will have to see a significant increase in conversion (visitation to purchase) of approximately 66 bps. Although NILE’s conversion rates on website traffic have been improvinig over the past 2-3 years, such a sharp increase in conversion in this consume environment could prove to be difficult. We think this could lead to a revenue shortfall for 2Q.
3. “Perfect Storm Comps Suggest Potential Upside to H2 Street Estimates“. The fact that NILE has easy comps is well known on the street and is factored into consensus estimates for the company.We have assumed the company is able to generate positive revenue growth in the fourth quarter. Interestingly enough, Citi’s optimism about revenue growth is predicated on an increase in average order value during both the third and fourth quarter. As the results of our proprietary survey of independent jewelers indicate, consumers have been trading down. Average order value has declined high single digits to low double digits on a YOY basis for the 45 independent jewelers we surveyed. We think NILE could have difficulty achieving 3.5% and 5.6% YOY increases in average order value in the third and fourth quarter as Citi currently forecasts.
4. “Positive Impact of Diamond Price Correction and Industry Consolidation“. Given NILE’s real-time inventory model for diamonds, we do expect the company’s gross margins to benefit from falling prices. The company should be better positioned to lower prices than its peers. According to our survey of independent jewelers, approximately 65% of respondents purchased more than 50% of their diamond inventory prior to 2009. This is one of the few favorable tailwinds NILE currently has, in our opinion. Industry consolidation and the huge number of store closures will benefit SIG far more than it will impact NILE, in our opinion. We think SIG will continue to take significant market share in this downturn given its strong brands and rapidly improving balance sheet.

Update on Diascience Corp. Lawsuit

As we mentioned in our original post, the Diascience Corp. lawsuit against Blue Nile has the potential to do considerable damage to the trust NILE has built with consumers. We cannot speak to the veracity of the suit, but if the case gains traction in the media it could significantly change the perception of Blue Nile. We have learned that Blue Nile’s motion to dismiss the suit was denied and the case has now entered the discovery phase. We think NILE investors should keep a watchful eye on the proceedings over the coming months as the potential for negative headlines in conjunction with the discovery process has now increased.

Overall, we continue to see considerable more upside in SIG shares than we do NILE and recommend investors consider a pair trade long SIG/short NILE. We think SIG shares could trade as high as $28 as comps improve and the company generates substantial free cash flow, while we see downside for NILE shares below $30, materially lower if the lawsuit escalates.

As always, please act accordingly…