We wanted to highlight a few noteworthy developments related to our pair trade recommendation of long SIG/short NILE.  First, we wanted to provide you with some detail on insider selling by Blue Nile executives over the past 6-9 months.  Second, it appears that NILE has entered into settlement discussions with Diascience Corp. (aka Yehuda Diamonds).

Insider Selling at NILE Continues Unabated

NILE issued two form 4’s with the SEC after the close yesterday, which indicated that both the company’s Chairman, Mark Vadon and CEO, Diane Irvine had once again sold stock.  This is not a new phenomena; executives at NILE have been large sellers of company stock over the past 6-8 months during a period in which shares have traded between $45-$65.  In the table below we outline all of the insider trading activity by key NILE executives since 6/1/09.  Here are some of the highlights of insider transaction activity at NILE over the past eight months

• No executive has purchased stock
• Executives have sold stock or exercised options for total proceeds of $17.1 million
• None of the options exercised were approaching expiration
• NILE’s Executive, Chairman Mark Vadon has reduced his holdings of NILE shares by 45% and generated $14.4 million in the process (not all of the sales were under the 10b5-1 plan)

Source: Company reports, PAA Research

Historically, insider sales have had little impact on stock price performance for NILE.  However, we have to wonder if the consistency and magnitude of recent sales should be viewed as a statement on management’s perception of the current valuation afforded to NILE shares.  At 71x and 55x consensus FY09 and FY10 EPS estimates, respectively we would argue that NILE’s valuation is nothing short of egregious.

Diascience Corp. (aka Yehuda Diamonds) Lawsuit Appears Headed for Settlement

One of the risks we highlighted in our original reporton our pair trade idea long SIG/short NILE was the potential that a lawsuit filed against Blue Nile could damage the company’s brand.   In the lawsuit, Diascience Corp. alleges that Blue Nile failed to disclose “enhancements” made to some of the gemstones the company sells. Our short thesis on NILE has been predicated in part (a very small part) on the view that potential escalation of the lawsuit could create media attention and damage the trust Blue Nile has build with customers over the past decade.  We would argue that consumer trust is the single most important element of NILE’s business model.  Anything that impairs that trust could imperil the company’s business model.

It appears for now that the risk that the Diascience Corp. suit could escalate and create a significant amount of media attention has been reduced.  Based on a recent legal filing, we have learned that NILE has entered into settlement discussions with Diascience Corp.  It appears that a settlement agreement could be reached by the end of the month.  It is difficult to say how large the settlement could be.  The two companies had entered the discovery phase of the case and to our knowledge no potential damages have been entered by the plaintiffs. NILE had more than $40 million in cash on hand and no debt as of 9/30/09, which is likely to be more than sufficient to pay any settlement.  The only remaining question is whether or not NILE’s decision to settle the case creates a precedent that could induce other participants in the jewelery space to seek damages against the company.  Stay tuned.

We continue to view long Signet Jewelers/short Blue Nile as a compelling pair trade idea.  We view Signet Jewelers as the best investment vehicle in the specialty jewelry space based on its strong geographic footprint, well known brands, and growing web presence which has enabled the company to gain significant market share in the downturn.  Additionally, the company is effectively long gold, silver, platinum and diamonds, which should lead to margin expansion in an inflationary environment.   For Blue Nile, we think shares could see considerable downside if the Diascience Corp. lawsuit escalates or creates a precedent for other jewelry industry participants to seek legal action against NILE.  Additionally, we think the fundamental short thesis is equally compelling: 1) the company has a significant operating margin conundrum, it is promotional in a downturn and squeezed by higher commodity costs in an upturn, and 2) the company will face increased competition from more sophisticated web-retailers and established onsite specialty jewelers that are expanding their web-presence.  Clearly, these concerns are not yet embedded in the valuation of NILE shares.  The stock now trades at 71.3x consensus FY09 EPS and 55.3x consensus FY10.  

We see downside in NILE shares towards $30 if investors embrace some of the fundamental flaws in NILE’s business model and/or ongoing legal activity creates a substantial amount of negative publicity.  At 15-17x our FY11 EPS estimates SIG would trade as high as $33-$36.

As always, please act accordingly…