We introduced a pair trade idea in June to go long Signet Jewelers against a short position in Blue Nile.  Although we characterized the idea as a “Pair Trade with Some Sparkle“, it has been anything but that so far.  The trade has generated a 1.3% net loss since the original date of recommendation.  Our original thesis remains as compelling today as it was four and half months ago:

1. Demand for jewelry is generally not as bad as people think, even though polished diamond prices have yet to show any signs of an increase.
2. SIG will be the direct beneficiary of store closures and tighter inventory management by its competitors.  We view SIG as the best investment vehicle to play a recovery in demand for jewelry based on the company’s large geographic footprint, well-known brands and strong balance sheet.
3. Blue Nile will increasingly face more sophisticated and widespread competition from traditional jewelers in addition to well established ecommerce players such as amazon.com.
4. Blue Nile has a significant “operating margin conundrum”.  In a downturn the company is more promotional in order to preserve demand, while in an upturn the company’s gross margins are squeezed by higher commodity costs. Just as the economic downturn destroyed the secular growth thesis for NILE, we anticipate a recovery could dismiss the notion that NILE has an operating margin expansion story.  The only environment in which we can foresee margin expansion for NILE is one of price stability and economic growth, which does not seem to be in the cards based on current monetary and fiscal policy trends.
5. The Diascience Corp. lawsuit against Blue Nile could create negative headlines about the company or otherwise damage Blue Nile’s brand.
6. In a “tale of the tape” between SIG and NILE, SIG shares appear to be more compelling across almost every valuation metric we look at.

In advance of NILE’s 3Q09 earnings release after the close on 11/5/09, we wanted to revisist some of the elements of our “operating margin conundrum” thesis to see how commodity costs could impact the company’s 3Q09 results and 4Q09 outlook.  As a reminder, NILE purchases inventory on a real-time basis.  In theory, the company should generate significant operating margin expansion during periods of commodity cost weakness.  In the first and second quarter, NILE’s gross margin increased 140 and 100 bps, respectively due to lower polished diamond and platinum prices.  According to IDEX online, polished diamond prices declined approximately 15% YOY during 3Q09.  For the most part, diamond prices remained flat sequentially over the course of the quarter.

Source: IDEX Online

This should be favorable for NILE’s 3Q09 results.  However as we have discussed here and here, we think there are growing signs that a floor in polished diamond prices has been reached based on sequential improvement over the past few months in rough diamond prices and reduced imports of polished diamonds to the US throughout the year.  Additionally, NILE’s gross margins could be pressured by rapidly increasing gold and platinum prices.  For the third quarter, gold and platinum prices increased 4.2% and 5.2% from 2Q09 levels, respectively.  Gold prices for the third quarter were up more than 10% on a YOY basis.  Thus far in the fourth quarter, gold and platinum prices have increased another 8% sequentially from third quarter levels. As the chart below indicates, NILE’s gross margins have historically been NEGATIVELY correlated to changes in gold and platinum prices.  We currently forecast 100 bps of gross margin expansion for NILE’s 3Q09 and 50 bps of gross margin expansion in 4Q09 based on the recent move in gold and platinum prices.  An uptick in polished diamond prices combined with higher precious metal prices could lead to lower gross margins for NILE in 2010, which is not yet factored into consensus.

Source: Company reports, Kitco, PAA Research

Over the course of 3Q09, it appears that NILE was slightly less promotional than the company was in 2Q09 and 3Q08.  Based on our analysis of the company’s email marketing campaigns, we estimate that NILE offered discounts during 26 days during 3Q09 compared to 35 in 2Q09 and 37 in 3Q08.  On a year-to-date basis, the number of days that NILE has offered a promotion is roughly the same at this point in the year as that in 2008.  The type of promotion also has been roughly similar (10% off, $100 of diamonds).  We have learned that the company will offer a 20% discount on select jewelery items during the holiday season as it did a year ago.

Our 3Q09 and 4Q09 Estimates Vs. Consensus

We currently forecast revenues and EPS of $64.4 million (-1.5% YOY) and $0.15 compared to consensus of $65.3 million and $0.16 for the third quarter.  According to Compete.com, the total number of unique visitors to bluenile.com declined 23.5% YOY in the third quarter.  In the month of September, traffic was down 16.8%  YOY, despite the fanfare surrounding the launch of the new bluenile.com website design.  Over the past few quarters the company has been able to convert a higher level of its traffic to actual transactions; this trend will have to continue if NILE is to meet consensus estimates.

Source: Compete.com

As we mentioned earlier, our 3Q09 EPS estimate is predicated on 100 bps of gross margin expansion YOY.  We forecast operating margins of 5.3% for the quarter, which would represent a 30 bps increase YOY.  For the fourth quarter, we currently forecast revenues and EPS of $94.4 million (10.0% YOY growth) and $0.32 compared to consensus of $95.9 million and $0.33.  We would argue that the bar set by consensus for the fourth quarter is reasonably high given some of the challenges NILE faces from a competitive perspective, tepid website traffic, and commodity cost headwinds.   At 70x and 56x FY09 and FY10 consensus EPS estimates, there is little valuation support for NILE’s current share price.  NILE currently yields 3.5% on a free cash flow basis, which is relatively anemic compared to other consumer-oriented cyclical companies.  We continue to see significant downside to NILE shares.

As always, please act accordingly…