Specious Argument

Just some quick thoughts as we close out the quarter. When I last wrote about Blue Nile (NILE) on 17 May 2010, the stock price was near $50.50. At the time, I expressed bullishness with concerns about Europe. Since that time, the financial news has been dominated by European woes, yet Blue Nile remaining relatively strong, closing today at just over $47.00. Moreover, the U.S. is experiencing a horrific environmental catastrophe in the Gulf of Mexico that is adversely affecting those living along the Gulf Coast. And, as we have seen, June's job release was disappointing. Given all these negative factors, I am surprised that Blue Nile's stock is doing as well as it is. If Blue Nile's upcoming earnings release is reasonable, then bears will have even more challenges.

I am surprised by the low stock value of Exxon Mobil Corporation (XOM). While some might point to its takeover of XTO, XTO was less than one-tenth the size of ExxonMobil. In other words, even if it overpaid for XTO, it does not deserve its current low valuation. And, there are rumors that ExxonMobil might buy BP p.l.c. (BP). I doubt strongly that ExxonMobil is interested in acquiring BP. There are too many unknowns in terms of environmental damages and costs. Moreover, because BP is an important crown jewel in the United Kingdom--according to Wikepedia on BP, BP is its largest corporation--ExxonMobil does not want to get involved in the political considerations.

On the positive side, in looking at the Wall Street Journal's Market Data today, I note that ExxonMobil led the Money Flows: Buying on Weakness. For total money flow, $176.66 million flowed in. That is, $414.93 million were bought on an uptick versus $238.27 sold on a downtick. The up/down ratio is 1.74. If we look at block trades, it is even more impressive with $188.75 million bought on an uptick versus $11.88 sold on a downtick. The up/down ratio is 15.89. ExxonMobil sports a dividend yield over 3%, has over $32 billion in long term investments, and, according to Yahoo! Finance, has a forward pe of less than 8.5. Oil prices are reasonably strong and forward curve indicates future strength. I view ExxonMobil's current stock price as a bargain.

Those wanting more information on the XTO transaction should listen to ExxonMobil's conference call on 8 July 2010. Below is a quote from a recent news release.

ExxonMobil will conduct an analyst conference call on Thursday, July 8, 2010 at 11 a.m. Eastern Time (10 a.m. Central Time) to discuss the transaction (URL will be available at www.exxonmobil.com).

The slides to be discussed during the call will be available at www.exxonmobil.com for viewing and download starting at 10:45 a.m. Eastern Time (9:45 a.m. Central Time) on July 8, 2010.

Audio Webcast Participation

Listen Only Numbers:
Domestic: 877-780-3379
International: 719-325-2269
Confirmation Code: 9648931

Disclosure: I am long Blue Nile shares; long ExxonMobil shares, and long and short puts in ExxonMobil for an overall net long position.

On Wednesday, 23 June 2010, I worked with a model Anya in Banff National Park. When I say worked, she was kind enough to allow me to practice my photography skills. If you click on my Flickr profile link, you will be taken to Flickr where you can see more of my pictures.

My last Blue Nile (NILE) conference call article was Third Quarter 2009. Back then, Blue Nile's stock price was $60.84, and this past Friday it closed at $50.53. I was bullish then and I remain bullish now.

Some will point to a substantial drop in stock price as evidence that I was wrong. While that is true, I suspect only a few of the bears were able to top tick the short at its recent high. Please see the two year price chart below. Blue Nile generally has extraordinarily high short interest, with Yahoo! Finance reporting its current short interest at 33 days or 55.4% of the float.

Please note, you can click on the charts to see full-sized images.

On 15 February 2010, Barron's Magazine wrote a bearish article. Let's look at a few brief snippets from the article and then move forward to the latest conference call.

One investor who has sold the stock short and asked not to be identified thinks it could fall to 35, given weak demand and intense competition in the fine-jewelry market. He said he might cover his short position if the shares hit 40.

...

Yet data on unique visitors to the company's Website suggest cause for concern. According to Compete.com, a Boston-based analyst of online data, the number of unique visitors to Blue Nile's Website declined year over year nearly every month in the past year, while many bricks-and-mortar jewelers, Tiffany included, saw increased traffic from visitors on the Web. Based on Compete's data, Blue Nile controls 4.3% of Internet jewelry sales.

Viewed over two years, the number of unique visitors to Blue Nile's Website also is down sharply. In November and December of 2007, big months for jewelers, Compete counted a total of 823,684 unique visitors to the company's site. In the same two-month stretch of 2008 it counted 681,666; last year it clocked only 583,697.

One unidentified investor who is afraid to attach his or her name to his or her comments thinks the stock could fall to $35. Of course, anything is possible, especially now with the world's financial order at the edge of the precipice. However, since the stock never fell to $40, is he or she still short? If so, it must have been an interesting ride from $48.18 on 17 February to over $58 in mid-April to back to nearly $50 now.

Next, we get the same old web traffic companies trotting out bogus statistics. Earlier in a prior article, I debunked their claims. And if that weren't enough, let's look at the historical revenues as shown by the chart below.

How can it be that sales are increasing while ...the number of unique visitors to Blue Nile's Website also is down sharply? Over the past two years, what are the cumulative reductions in web traffic reported by comScore? By Compete? If their trends continue, when do Blue Nile's servers fall silent with Blue Nile experiencing increasing revenues?

And, of course, the article discussed a planned sale program by the executives as evidence that all is not well. The executives have sold stock high and low. They are merely exercising prudent financial management by diversifying their net worth.

As we'll soon learn, Blue Nile purchased stock at an average price of $52.04. You must ask yourself, if insiders believed that Blue Nile was destined for $35 per share, as our anonymous short seller believes, would it not be prudent to wait? Of course, management cannot predict with any accuracy--nor can anyone else--the stock price tomorrow, next week or next month. Instead, management must use its judgment and make an informed decision as to whether purchasing stock and returning cash to shareholders now makes sense.

Now let's turn our attention to the press release and recent conference call. I will use point form.

Press Release

• Record first quarter sales of $74.1 million, representing growth of 19%.
• Non-GAAP adjusted EBITDA (earnings before interest, taxes, depreciation, and amortization) grew at 17% to $6.2 million.
• Earnings per diluted share increased 23% to $0.16.
• Operating margin expanded 10 basis points to 4.8% of net sales compared to Q1 2009.
• Net income improved 23.1% to $2.4 million or $0.16 per diluted share compared to $1.9 million or $0.13 per diluted share Q1 2009.
• Net cash provided by operating activities totaled $29.8 million for the trailing twelve month period ended April 4, 2010.
• Non-GAAP free cash flow for the trailing twelve month period ended April 4, 2010 increased 133% to $27.5 million from $11.8 million a year ago.
• International sales increased 71.4% to $9.6 million, a new company record. Excluding foreign exchange effects, international grew at 51.8%.
• Gross profit totaled $15.8 million. As a percentage of sales, gross profit improved 10 basis points to 21.3% compared to 21.2% for the first quarter of 2009.
• Selling, general and administration expenses were $12.2 million, compared to $10.3 million in Q1 2009. Percentage wise, SG&A costs were the same as Q1 2009.
• Net income per diluted share for the quarter includes stock-based compensation expense of $0.08 for both the first quarter of 2010 and 2009.
• During the quarter, the Company repurchased 292,100 shares of its common stock for $15.2 million. At the end of the first quarter, cash and cash equivalents totaled $47.2 million (which calculates to an average price of $52.04 per share).
• Expectations for the full year 2010 (Year Ending January 2, 2011):
  • Net sales are expected to grow at least 15% over 2009 levels; and
  • Diluted earnings per share are expected to grow at least 20% over 2009 levels.

Conference Call (skipping over much of the information already covered by the press release)

• Traffic to Blue Nile's web site grew y-o-y, and conversion increased to an all-time high. Company experienced healthy increases in orders and average sales price. Repeat sales showed strong growth for the quarter.
• Sales of non-engagement jewelry grew above overall average sales growth rate. Customers made more discretionary purchases than a year ago.
• Strongest growth was at price points above $25,000, with total sales for price points above $25,000 near record Q1 levels.
• Company believes it is continuing to gain market share by offering high-quality diamonds that are 20% to 40% below physical retailers and world class high-touch customer service.
• In the first quarter, international sales increased 71% to $9.6 million, representing 13% of total sales.
• Its new Chinese language web site, launched in early April, was Blue Nile's first non-English language web site.
• Current web site features new enhancements. First, customers are able to store their order histories, which simplifies the repeat purchase process and provides wish list functionality along with other benefits. Second, new financing options are available. And third, a new diamond and jewelry search. iPhone and Android mobile devices can compare prices, quality, and search more than 60,000 diamonds.
• Sales in the U.S grew at 13.6%, with international sales at 71.4% or $9.6 million. On a constant currency basis, international sales grew at 51.8%. Strong growth was evident in U.K. and Canada. There was strength in the Asia, Pacific, and European markets.
• SG&A totaled $12.2 million for the quarter, compared to $10.3 million in the first quarter of 2009. SG&A included $1.8 million in stock compensation expense in the first quarter of 2010 and 2009. Excluding stock-based compensation expense, SG&A as a percentage of sales was 14.0%, compared to 13.7% in the first quarter of 2009.
• The increase in SG&A is partially attributable to higher marketing this year over last year. Last year, Blue Nile reduced its advertising in response to the harsh economic conditions. Current levels are near normal levels.
• There were also investments in technology as part of the G&A increase.
• Operating income for the first quarter totaled $3.6 million, representing an operating margin of 4.8%, a 10 basis point improvement from our 4.7% operating margin a year ago.
• Company ended quarter with a cash balance of $47.2 million. Every Q1, company incurs a significant payables hit from Q4. Moreover, 292,100 shares were purchased for 15.2 million (which translates to $52.04 per share). Blue Nile still has about $100 million approved for additional purchases.
• Inventory was 21.3 million, an increase of $1.8 million from Q1 2009. Although this level is slightly above ideal, the Company is preparing its spring launch and providing additional product depth. During the year, Blue Nile expects inventory to return to historical levels.
• Inventory turnover for the trailing 12 months improved to 13.6 in Q1 2010 from 12.8 in Q1 2009.
• Return on invested capital, defined as trailing 12-months free cash flow divided by the average total assets, less current liabilities for the past five quarters, was 81% for Q1 2010, compared to 48% in Q1 2009.
• Guidance:
  • Maintaining sales growth at 15% or greater and diluted earnings per share at 20% or greater.
  • Capital expenditures at about $3 million.
  • Quarterly guidance has been dropped in favor of a longer-term focus.

Question and Answers

• Fluctuating currencies presents challenges and opportunities. As the British pound and Euro lose value, headwinds are created in U.K. and Europe. However, because the U.S. dollar is relatively stronger and diamond values tend to depreciate in U.S. dollar terms, U.S. consumers have more purchasing power.
• Diane Irvine mentioned that Blue Nile experienced a solid April.
• When repurchasing shares, Blue Nile does establish target levels at which it wants to purchase shares. If shares are trading above trading levels, Company waits until an opportunity presents itself rather than acting in an aggressive fashion by chasing higher price levels.
• Mark Vadon stated, "I just wanted to throw out one more think about, as we are looking at traffic growth and conversion. Again, this quarter we had a third-party firm announce that they thought our traffic was down a pretty alarming amount. And this seems to happen every quarter. And the market seems to react to it every quarter. And we always tell people we're sitting here looking at our servers, and that data from third parties is not accurate. So, I would just want to take this moment to caution people to try not to pay so much attention to third parties who actually don't have real data."
• Diane Irvine commented that, ignoring growth considerations, Q4 is the largest quarter with Christmas. Next is Q1 with Valentine's Day. Next is Q2 with Mother's Day. Q3 is lowest in sales but highest in margins because there no important holidays to drive sales and engagement rings. Thus, there are a higher proportion of jewelry sales in Q3 that carry a higher margin. With the company growing rapidly, these trends are sometimes influenced by Blue Nile's underlying growth. In other words, these are guidelines but not absolutes.

After reviewing this conference call's information and absorbing the market events during the past two weeks, I believe the analysis is simple. If problems in Europe continue to worsen significantly, then that event might cause trouble for most American stocks too, including Blue Nile's. If, on the other hand, Europe stabilizes and America continues to recover, then I expect Blue Nile's stock to outpace most others.

During the conference call, Blue Nile indicated that as the Euro falls, the U.S. currency becomes relatively stronger and the U.S. consumer is able to purchase more diamonds, because, although diamonds are priced in U.S. dollars, they would likely fall in price. While I agree with that statement as given, there is one part missing. If European troubles escalate rapidly, then all economies are likely to slow and consumers become cautious.

For those that believe that Europe will continue to deteriorate rapidly, they should avoid Blue Nile. And for those that believe that we are recovering, then they should consider Blue Nile. As evidenced by most metrics, Blue Nile continues to execute superbly in an industry that is faltering and in disarray. Moreover, Blue Nile continues to gain market share by offering quality products at substantially lower prices. Simply put, the company continues to grow, even in a difficult market.

We have also learned that Blue Nile is a willing buyer of its own stock at a price of around $52. This price is subject to change, however. If problems in Europe escalate, I am sure that Blue Nile would reduce its target level for purchasing more stock, if not stopping altogether. Do I expect to see the $35 target price of our mysterious short seller? No. On the other hand, if the markets stabilize and resume growth, the target level might even be raised.

The other consideration is Blue Nile's international growth. As revealed during this conference call, Blue Nile is enjoying rapid international growth. What is especially important is that Blue Nile can continue to serve more markets at a very low cost because its business model is capital light. Recall that the return on invested capital is an amazing 81%.

I have deliberately not commented on various metrics such as price-to-earnings multiples and such. The reality is, Blue Nile stock always has high price-to-earnings multiples. Moreover, the uncertainty surrounding key inputs such makes most valuation formulas tenuous at best. One analyst might forecast low growth rates while another might forecast significantly higher growth rates. These growth rates are highly dependent upon the recovery. Once the world economies stabilize and we can better estimate future growth trends, then I will place more emphasis on valuation formulas.

In assessing Blue Nile, the question effectively becomes: Are we experiencing a recovery where consumers will continue to spend discretionary funds or are we about to experience another severe economic shock that will cause consumers to become extraordinarily cautious again?

Disclosure: I am long Blue Nile shares.

On Saturday, 15 May 2010, I photographed Glenmore Reservoir while looking west. If you click on my Flickr profile link, you will be taken to Flickr where you can see more of my pictures.

With natural gas prices hovering around four dollars per million British thermal units, many have been wondering if it makes sense to use natural gas as a transportation fuel. Indeed, I was curious myself.

When Exxon Mobil Corporation (XOM) held its analyst meeting 11 March 2010, Rex Tillerson, Chairman and Chief Executive Officer, responded to a question about using natural gas as a transportation fuel.¹

Well, we think gas as transportation fuel has a lot of limitations. There have been a number of studies done. We have done our own. I could also refer you to the EIA's recent study just done in 2009 that they published, and we would concur with their conclusions, and that's that natural gas as a transportation fuel will probably never be particularly attractive. But it's due to basic physics.

The density of the fuel that you can put on board the vehicle is a limitation. It is a gas. It is not a liquid. So when it competes with whether it's conventional gasoline, diesel or biofuels, liquid biofuels, density is a problem. To get more comparable energy on board means you've got to either pump it up to higher pressures or you've got to put bigger storage tanks.

So it has some limitations with respect to the range of the vehicle operation. It has some limitations with refueling, not just the fact that there's an absence of refueling stations, but a refueling modification to it at conventional retail site is about $1 million. If you're a mom and pop dealer, that's next to impossible to do without a lot of help.

Then, when you pull up to that station to refuel, it takes a little longer than when you're putting on board liquid fuel. The question of using it in tractor trailer, cross-country transportation, I just, for all the reasons I just described, that one, I can't make the math work on why anybody would do that.

Now having said that, there are -- and CNG vehicles have been around a long time. They've been around in fleet service for 30, 40 years. I mean, the technology itself, there's nothing new about it, and there's not much you can do to the basic physics and thermodynamics to improve it.

But where you have fleet operations, municipal buses, taxi cabs, a company, that have large fleets of service vehicles, utilities where the vehicles all come back to one central location every night, you can afford the cost of installing a refueling system where you can refuel these vehicles simultaneously overnight. You can get enough fuel on board that they basically can make their daily rounds and come back. That could make sense for someone.

The cost of converting a vehicle is not insignificant. So you've got an upfront capital cost. So for all of those reasons, we just do not see natural gas as a viable transportation fuel. We don't think the consumer is going to particularly be pleased with what they have to do.

From an economic standpoint, there's really not the kind of gain that people think there is. From an emission standpoint, the kind of best case, you do get about a 15%, best case, 20% reduction in CO2 emissions, well-to-wheels on a CNG vehicle versus a conventional internal combustion gasoline engine.

An internal combustion gasoline engine has got a lot of room to get better, and it's going to get better. It is getting better. So that's going to always compete against this other alternative as well.

With kind assistance from the folks at U.S. Energy Information Administration (EIA), I was able to locate Natural Gas and Crude Oil Prices in AEO2009, which I believe is the EIA study Tillerson referred to earlier.

Substitution of Natural Gas for Petroleum Consumption

In a relatively high oil price environment, as in the AEO2009 reference and high oil price cases, consumers can reduce oil consumption through energy conservation and by switching to other forms of energy, such as natural gas, coal, renewables, and electricity. Natural gas is not necessarily the least expensive or quickest option to implement (in comparison with reducing transportation vehicle-miles traveled, for example).

In the residential, commercial, and electric power sectors, petroleum consumption is relatively small, accounting for only 6.5 percent of total U.S. petroleum consumption in 2007. Gradually converting all the petroleum consumption in those sectors to other fuels would have only a modest impact on natural gas consumption and prices.

In the industrial sector, the most feasible opportunity for substituting natural gas for petroleum is in heat and power uses, which amount to about 0.61 quadrillion Btu per year [70]; however, most petroleum consumption in the industrial sector (such as diesel and gasoline consumption by off-road vehicles in agricultural and construction activities; petroleum coke; refinery still gas, which is both produced and consumed in refineries; and road asphalt) is not well suited for conversion to natural gas. Also, there is considerable uncertainty about the extent to which petroleum feedstocks for chemical manufacturing could be replaced with natural gas before 2030. At a minimum, considerable downstream investment in chemical manufacturing processes would be required in order to convert to natural gas feedstock.

The greatest potential for large-scale substitution of natural gas for petroleum is in the transportation sector--especially, in local fleet vehicles refueled at a central facility, such as local buses, which consumed 0.18 quadrillion Btu in 2006 [71]. Wider use of natural gas as a fuel for transportation fleets also has been advocated; however, the idea faces significant hurdles given the relatively low energy density of natural gas; the cost, size, and weight of onboard storage systems; and the challenge of establishing a refueling infrastructure. In addition, any significant increase in natural gas use could raise natural gas prices sufficiently to reduce the ratio of natural gas prices to oil prices.

The Honda Civic GX and Civic LX-S vehicles provide a uniform basis for comparing the attributes of a natural-gas-fueled LDV (the GX) and a gasoline-fueled LDV (the LX-S) that use the same design platform (Table 13). The Honda GX is about 34 percent more expensive, carries 39 percent less fuel (resulting in a much shorter refueling range of about 200 to 220 miles), and provides 50 percent less cargo space, 19 percent less horsepower, and 15 percent less torque. Although natural gas has a high octane rating of 130, the GX horsepower and torque are reduced by the rate at which natural gas can be injected into the piston cylinders because of its lower energy density.

Although the higher cost and other disadvantages of natural gas vehicles could be offset at least partially by their lower fuel costs, the lack of an extensive natural gas refueling infrastructure will remain a difficult hurdle to overcome. Consumers are unlikely to purchase natural gas vehicles if there is considerable uncertainty as to whether they can be refueled when and where they need to be. Similarly, service station owners are unlikely to install natural gas refueling equipment if the number of natural gas vehicles on the road is insufficient to pay for the infrastructure costs.

In 2008, there were only 778 service stations in the United States with natural gas refueling capability out of a total of more than 120,000 service stations [72]. Public refueling capability for natural gas, ethanol, methanol, and electric vehicles has fluctuated considerably over time, as the different vehicle options have gained and lost favor with the public. Even after the more than 15 years that these alternative fuel options have existed, fewer than 1 percent of the Nation's public service stations currently offer refueling capability for any alternative fuel.

Without an extensive public refueling network, the potential for market penetration by natural gas vehicles will be limited, and until a substantial number have been purchased, an extensive public refueling network is unlikely to develop. Market penetration by natural gas vehicles is also limited by the many alternatives that consumers have for reducing vehicle petroleum consumption, including buying smaller vehicles, reducing vehicle-miles traveled, and buying hybrid electric or, potentially, all-electric vehicles. In addition, price volatility in crude oil and natural gas markets obscures the long-term financial viability of natural gas vehicles. Consequently, AEO2009 assumes that widespread adoption of natural gas vehicles in the United States is unlikely under current laws and policies.

One item that neither Tillerson nor EIA mentioned is that natural gas and propane vehicles cannot be parked in enclosed areas such as underground parkades. If there were a small leak of natural gas or propane, it could create an explosive situation when the gas contacts an ignition source, such as a spark or cigarette.

Along with many others, at first I thought natural gas might be an ideal gasoline substitute. But after listening to Tillerson's comments and reading the EIA's work, I am now a skeptic. I found this information interesting, and I hope you did too.

Disclosure: I am long XOM stock and long XOM puts and short XOM puts for a net long or bullish position.

¹ I used Morningstar Document Research, formerly called 10KWizard, to obtain Exxon Mobil's analyst day information. You can also retrieve this information directly from Exxon Mobil's Exxon Mobil investor's site. If, when you search for the document, it is no longer present on Exxon Mobil's site, you can still find it at SEC.gov using XOM as the search term. Once you find the list of corporate filings, then search for an 8-K listing on 2010-03-17.

On Sunday, 21 February 2010, I photographed River Cafe in Prince's Park in downtown Calgary. For those interested, you can view this location using Google Maps. Now that it is April, I need to take some pictures without all the snow. If you click on my Flickr profile link, you will be taken to Flickr where you can see more of my pictures.

I have been busy recently so I haven't commented on my blog as much as I would have liked. I plan to comment more frequently this coming quarter.

As far as trading and investments are concerned, I found this past quarter difficult. Some energy related names have performed poorly compared to my expectations. And, concerning the broader market, I am still trying to determine whether we are recovering from the recession or simply enjoying a respite. There are so many conflicting datapoints and opinions. I expect that once the current earnings season ends, we will understand the markets better.

Once again, I look forward to blogging on a more frequent basis this coming quarter.

On Sunday, 21 February 2010, I photographed a bridge crossing the river to downtown Calgary. For those interested, you can view this location using Google Maps. If you click on my Flickr profile link, you will be taken to Flickr where you can see more of my pictures.

Congratulations to Canadian Olympic Athletes! In Vancouver 2010 Olympics, Canada won 14 Gold, 7 Silver, and 5 Bronze medals. Canada holds the record for the most gold medals in a Winter Olympics. All Canadians are proud of all our athletes and their accomplishments.

I just finished watching Hockey gold medal game between the United States and Canada, with Canada winning 3-2 in overtime where it was four on four. Watching Canada give up its 2-0 lead with the last goal scored in the remaining 24 seconds was certainly difficult. I am sure all Canadians were sitting on the edge of their seats. Fortunately, Sidney Crosby scored the goal at 7:40 in overtime.

Team USA played extremely well throughout the entire Olympics. They are a young team that many expected would exit early. In fact, they had to rebook their flights because of their unexpected final gold medal game. Congratulations to Team USA on their silver medal.

Congratulations to all athletes from all countries. I hope you enjoyed your stay in Canada.

Finally, my heartfelt sympathies to the family of Nodar Kumaritashvili and all those who knew him. Nodar Kumaritashvili was the Georgian luger athlete who died while practicing prior to the start of the Olympics. I hope his death causes the International Luge Federation to examine the safety of all tracks.

Again, congratulations to all Canadian Olympic Athletes!

On Thursday, 10 September 2009, I photographed Calgary model Anya near Mount Rundle in Banff National Park, Alberta. If you click on my Flickr profile link, you will be taken to Flickr where you can see more of my pictures.