JACKSON SECURITIES, LLC

Research for the Prudent Investor

Date 2/7/07 Blue Nile (NILE): Initiating

Current Price $39.18
Coverage with a “HOLD”
52WK HI $39.99
52WK LO $24.10
recommendation
EPS (TTM) $0.71 • Industry: Internet Services HOLD initiated 2/7/07: $39.18
Shares Outstanding 16.1M • NILE: NASDAQ; $39.18 Target: $40.00
Market Cap. $627M • 12-month price target: $40.00
Dividend Yield NA
Price/Earnings (TTM) 55X
Price/Sales (TTM) 2.6X
EV/Revenue (TTM) 2.3X
EV/EBITDA (TTM) 25.8X
EBITDA (TTM) $20.8M

Brian Bolan
Company Description
Director of Equity Research Blue Nile is a leading online retailer of high quality diamonds and fine
Technology jewelry. Blue Nile specializes in the customization of diamond jewelry with
a “Build Your Own” feature that offers customers the ability to customize
Jackson Securities, LLC
300 S. Wacker Dr., Suite 2450
diamond rings, pendants and earrings. While not providing the lowest
Chicago, IL 60606 cost diamonds, the company believes its formula of no pressure sales,
high quality educational material and reasonable prices will result in higher
Ph: (312) 253-0578 profits.
Fax: (312) 986-0560
bbolan@jacksonsecurities.com
Valuation and Recommendation:
The lessons of the bubble era are apparently not lost on investors of Blue
Nile, but as the company grows, it could eventually create a perfect storm
in terms of a ballooning valuation. At the current time, we believe that the
company is one to two years away from that transformation and we initiate
coverage of the company with a HOLD rating.
Jackson Securities, LLC seeks to do business with companies covered in its
research reports. As a result, investors should be aware that the firm may have a
conflict of interest that could affect the objectivity of this report. Investors should
consider this report as only a single factor in making their investment decisions.
Please also refer to the important disclosures found on page numbers 9 and 10.
Analyst Certification is found on page number 9.
Blue Nile (NILE)

Introduction to Blue Nile

Founded in 1999 as RockShop.com, Blue Nile has grown from

humble beginnings into the one of the largest diamond and jewelry
retailers on the web. Utilizing a low inventory model, ubiquitous
presence and reasonable pricing the company is poised to
eventually reach a critical mass. At that point, the company can
further push margins more in its favor
which would improve earnings.

Engagement Ring Market

Around 72% of the sales at Blue Nile
involve engagement rings, a $4.5B
segment of the $57.2B overall jewelry
market. Of that overall market, diamond
jewelry accounts for approximately
$31.5B. With total sales of $200M in
2005, Blue Nile is just beginning to
scratch the surface of the total available
market.

The company has stated that the average

selling price (ASP) of an engagement
ring is around $5,600. Even when faced
with the possibility of rising commodity
Source: Blue Nile costs, we would expect that this number
would remain relatively constant as the budget for the ring does
not float up or down in relation to commodity prices. Over the last
few quarters, management has noted that platinum, gold and silver
have all seen fairly dramatic price increases. The company has
noted that they are passing those rising costs onto consumers.

A competitor of Blue Nile, Abazias (ABZS), which sells loose

diamonds via the web, states their ASP for engagement rings to be
$5,500. Tiffany’s (TIF) has stated their engagement ring ASP to
be around $9,500. We believe that that the ASP for engagement
rings to be among the most important metric for calculating sales
and valuation for Blue Nile.

The company has stated in the past that 15% of its transactions
have an ASP of greater than $20,000, thus Blue Nile is getting its
share of the high end market. In recent conference calls, the

JACKSON Brian Bolan 2

SECURITIES, Director of Research – Technology
LLC
Blue Nile (NILE)

company has highlighted the number of transactions over the

$100,000 price point and has even had a sale at a $345,000 price
point. We believe that this ultra-high end market, and specifically
the growth within, is a key idea when assessing the value
proposition of Blue Nile. As the company has stated, one of the
greatest barriers they face is that of trust. As these large purchases
indicate, the level of trust in not only the web model but the Blue
Nile brand is growing.

Industry Outlook

The market for diamond jewelry is highly fragmented and difficult

to gauge. With competitors ranging from Mom & Pop stores to
Wal-Mart, getting a real sense of the industry is difficult.

The competition is wide spread and comes from companies with

all different sizes. Tiffany (TIF) is more in the brick and motar
model which encourages users to shop at a local store after
learning about the potential purchase via the web. With sales of
$2.3B in 2005, Tiffany is significantly larger than Blue Nile and
carries a brand value that is better than that of Blue Nile. On
recent Tiffany conference calls management has noted that their
sales growth is in the mid single digits, far below that of the high
teens growth at Blue Nile.

Abazias (ABZA) is really on the other end of the spectrum. The

focus of the Abazias model is loose stones. The web-based model
also allows for many of the same advantages that Blue Nile has,
especially that of low inventory. However, for comparison
purposes, Abazias is almost too small, with annual sales of
approximately $3M and a stock that is traded on a very infrequent
basis. The company also recently announced a private placement
of $300,000 worth of restricted stock.

A business model that more closely reflects that of Blue Nile

would be that of Amazon. Amazon offers an online jewelry store
that is comparable to that of Blue Nile. Its trusted brand name and
millions of customers also give Amazon.com a leg up in the ‘trust
factor’. Due to the overall size of Amazon, the company does not
break out sales of its jewelry store versus its other lines, making it
somewhat difficult to estimate what portion of the $10.3B in total
sales for 2006 is coming from that market.

JACKSON Brian Bolan 3

SECURITIES, Director of Research – Technology
LLC
Blue Nile (NILE)

In 2006, Amazon had 4 press releases that noted its jewelry store
sales were “up more than 100 percent”. Amazon noted that in the
second quarter of 2006, sales of custom built engagement rings
increased 254% and its selection increased 30% to 2.6M unique
items. The third quarter of 2006 saw 108% growth in the jewelry
business. Clearly, all of these sales figures are coming from a very
small base, so it may be some time before these growth numbers
hold much merit. Until that point comes, an expectation of 100%+
from Amazon’s jewelry segment should be considered the standard
for the broad based online retailer.

Management Discussion

As important as the core of the diamond market is to Blue Nile, we

believe that the true value of the enterprise is online model that is
managed by a talented group led by CEO Mark Vadon. Possessing
deep knowledge of both the diamond industry and technology,
Mark has been instrumental in leading Blue Nile to its present
position.

Other key members of the management team include Diane Irvine

who has served as Blue Nile's Chief Financial Officer since
December 1999. Darrell Cavens has served as Blue Nile's Senior
Vice President since June 2005 and his former positions include
VP of Development as well as Blue Nile's Chief Technology
Officer from November 2000 to June 2005.

Earnings Analysis

In looking at our estimates, we felt we would be remiss if we

didn’t mention the idea of earnings growing at nearly 25% rate
while net income experiences growth of about 17%. This is clearly
due to the advanced share repurchase that is expected to occur
throughout the year.

We wanted to highlight this as any disruption in the buyback of

shares could have a dramatic effect on a potential EPS number that
many valuation calculations are based on. We believe that the
company will continue to repurchase shares, but are mindful that
an acquisition would likely boost the share count and would be
dilutive to earnings.

JACKSON Brian Bolan 4

SECURITIES, Director of Research – Technology
LLC
Blue Nile (NILE)

Share repurchases, short interest and Acquisitions

Blue Nile has been fighting a war in the trenches, a war against the
shorts. For some time, short sellers have viewed Blue Nile as a
jewelry retailer with a “Microsoft multiple” and thus view it as
overvalued. To combat this, the company has employed a strategy
of continued execution on the business plan and supporting its
stock through buybacks.

Monthly Price and Short Interet Ratio Short interest has moved from 14.1 to
24.2 over the past 6 months, even as
45 shares outstanding have been reduced
40 due to board approved buy backs.
35 Quick analysis of the patterns utilized
by the short sellers suggests that shorts
30
Price may load up for another push in late
25
SIR March through April. We would not
20 recommend that investors attempt to
15 time their purchase of shares in order to
10 enact a short squeeze.
5
With a fair amount of attention being
06
06

6
6
5

6
06

focused on the war with the shorts, the

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company has more or less backed itself

out of the acquisition market. We are
Source: Bloomberg not saying that presented with an opportunistic acquisition the
company will pass, but rather an acquisition might serve to dilute
shares and give the shorts a rallying cry.

During the third quarter, Blue Nile repurchased approximately

239,000 shares, or about 1.5% of the shares outstanding for an
aggregate purchase price of $7.8 million. Since the inception of
the share repurchase program in February 2005 through the end of
September 2006, Blue Nile has retired approximately 12.7% of the
outstanding shares. As of the end of the third quarter, $96.4 million
remains to be spent under the $150 million in stock repurchase
programs that have been authorized by the board of directors.

JACKSON Brian Bolan 5

SECURITIES, Director of Research – Technology
LLC
Blue Nile (NILE)

Ad Spend

As a percentage of total revenue, the company spends roughly 4%

on advertising. The company utilizes Cost-Per-Click (CPC)
keywords such as diamond, engagement ring, wedding ring,
wedding band and the like. The company has stated on its
conference calls that CPC prices have risen dramatically and the
company looks closely at the ROI’s involved. Over the last few
quarters the idea of outsourcing the ad spending to a specialist firm
has come up and could be a viable option for the future.

The company has refused to elaborate on its strategy to drive

traffic to the site. Some talk of being a large sponsor on a portal or
developing a portal has surfaced over the last year, but so have
calls for more offline ads. Currently, the company believes that
online advertising makes much more sense than off line ads and
doesn’t want to disclose its traffic strategy for competitive reasons.
We believe that in the coming quarters, the company may
announce that they will be spending more to acquire more
customers.

Risks

The risks involved in purchase of shares of Blue Nile include, but

are not limited to: consumer demand for its products, the costs
associated with procuring precious metals, wholesale diamond
pricing and general economic conditions.

Along with other boilerplate style risks that most technology

companies face (ability to stay current with technology platforms,
drive customer to the website, retain qualified personal to maintain
and operate the technical operations), Blue Nile faces some unique
risks. We view Amazon’s lackluster approach to the market as risk
as they may begin to increase their marketing spending in a effort
to steal potential customers.

We doubt that the hundreds of independents jewelers will be able

to fully organize and produce a website that would effectively
compete against Blue Nile, but in the event that it did happen, it
would be a viewed as a serious threat to the company.

JACKSON Brian Bolan 6

SECURITIES, Director of Research – Technology
LLC
 Blue Nile (NILE)

One of the biggest risks is if Wal-Mart decides to make a major

play at the higher end jewelry market. Wal-Mart’s website
currently offers jewelry on the lower end of the scale, most items
are priced under $1,000. Should Wal-Mart decide that they want
to compete in this market, margins would likely erode.

Valuation

Like any stock, we believe the primary reason an investor should

purchase shares is to capture earnings growth
TIF AMZN O STK NILE or earnings value. Coverage of the internet
P/ Sales 2.1 1.6 0.4 2.7 sector is synonymous with earnings growth,
P/ Net Income 22.5 55.7 NA 55.0 and a high growth rate at that. Blue Nile is
clearly growing its sales and earnings at a rate
O perting Margin 15.6% 4.0% -7.5% 6.8% higher than its diamond jewelry specific
Profit Margin 10.1% 3.0% -7.6% 5.4% counterparts, but does it deserve the
“Microsoft Multiple”?

Source: Yahoo! and JS estimates In determining our price target, we created a multiple matrix and
looked at where Blue Niles multiples landed based on our
estimates for FY07 and CY06. We also took at look at the margins
Valuation Matrix Multiple of four competitors. The accompanying
Price 36 37 38 39 40 41 42 43 44 charts are show to the left.
P/ Sales
CY06 2.4 2.5 2.6 2.6 2.7 2.8 2.8 2.9 3.0
CY07 1.8 1.9 1.9 2.0 2.0 2.1 2.1 2.2 2.3
While TIF carries higher margins, it has
P/ O perating Income lower growth. There is a very large
CY06 38.9 40.0 41.0 42.1 43.2 44.3 45.4 46.5 47.5
CY07 28.4 29.2 29.9 30.7 31.5 32.3 33.1 33.9 34.7 premium being paid for NILE when
P/ Net before tax
compared to TIF, and this gives us some
CY06 32.3 33.2 34.0 34.9 35.8 36.7 37.6 38.5 39.4 pause, but if the growth continues as
CY07 25.0 25.6 26.3 27.0 27.7 28.4 29.1 29.8 30.5
expected and margins eventually
P/ Net Income improve, we believe that buying shares
CY06 49.5 50.8 52.2 53.6 55.0 56.3 57.7 59.1 60.5
CY07 38.4 39.5 40.5 41.6 42.7 43.7 44.8 45.8 46.9 of NILE would be advisable. Currently
that is not that the case and we
Source: Blue Nile and JS estimates recommend that investors HOLD shares of Blue Nile.

JACKSON Brian Bolan 7

SECURITIES, Director of Research – Technology
LLC
 Blue Nile (NILE)

Thesis

Blue Nile is an excellent example of the idea of what an e-

commerce based company should be. Its meager beginnings and
accession to a leading position in the market underscores the
effectiveness of the Internet model. While the current competitive
environment and commodity price fluctuations have caused
concern, we believe that over the long term, the company will
reach a critical mass and be able to increase margins to the benefit
of shareholders.

Earnings Model for Blue Nile

Blue Nile In Thousands of U.S. Dollars 1st Qtr. 2nd Qtr. 3rd Qtr. 4th Qtr. 2006 1st Qtr. 2nd Qtr. 3rd Qtr. 4th Qtr. 2007
Estimate Estimate Estimate Estimate Estimate Estimate Estimate
(except for per share items)
Total Revenue 50,694 56,916 53,248 94,199 255,057 58,966 67,958 63,112 114,005 304,042
Cost of Revenue 40,325 45,568 42,817 75,454 204,164 47,468 54,571 51,121 92,344 245,504
Gross Margin 20.5% 19.9% 19.6% 19.9% 19.5% 19.7% 19.0% 19.0% 19.3%
Sell/General/Admin 7,704 7,746 8,271 11,304 35,025 7,960 8,835 9,467 12,541 38,802
SG&A as percent of sales 15.2% 13.6% 15.5% 12.0% 13.5% 13.0% 15.0% 11.0% 12.8%
Total Operating Expense 48,029 53,314 51,088 86,758 239,189 55,428 63,405 60,587 104,885 284,306
Operating Income 2,665 3,602 2,160 7,442 15,869 3,538 4,553 2,524 9,120 19,736
Operatin Margin 5.3% 6.3% 4.1% 7.9% 6.0% 6.7% 4.0% 8.0% 6.5%
Other Income
Interest Income 985 881 670 625 3,161 650 650 700 700 2,700
Other 0 100 1 0 101 0 0 0 0 0

Net Income Before Taxes 3,650 4,583 2,831 8,067 19,131 4,188 5,203 3,224 9,820 22,436

Provision for Income Taxes 1,295 1,451 1,007 2,904 6,657 1,466 1,821 1,129 3,437 7,853
Tax Rate 35.5% 31.7% 35.6% 36.0% 34.8% 35.0% 35.0% 35.0% 35.0% 35.0%

Net Income 2,355 3,132 1,824 5,163 12,474 2,722 3,382 2,096 6,383 14,583

Basic/Primary EPS Excl. Extra. Items 0.14 0.19 0.11 0.32 0.76 0.17 0.22 0.14 0.42 0.94
Basic/Primary EPS Incl. Extra. Items 0.14 0.19 0.11 0.32 0.76 0.17 0.22 0.14 0.42 0.94

Basic/Primary Weighted Average Shares 17,354 16,874 16,014 16,000 15900 15700 15500 15100
Diluted Weighted Average Shares 18,236 17,562 16,670 16,100 17,142 15900 15700 15500 15100 15,550

Source: Company Reports and Jackson Securities

JACKSON Brian Bolan 8

SECURITIES, Director of Research – Technology
LLC
Disclosures:

Analyst Certification
I, Brian Bolan, hereby certify that the views expressed in this research report accurately reflect my personal views about
the subject securities and issuers. I also certify that no part of my compensation was, is, or will be, directly or indirectly,
related to the specific recommendations or views expressed in this research report. I may be compensated in part based
on the overall profitability of Jackson Securities, LLC, which includes earnings from investment banking and all other
aspects of the firm’s business.

Conflicts of interest:
Neither Jackson Securities nor any of its publishing analysts or their immediate family members has a position in the
securities described herein.

Compensation:
• The research analyst has not received compensation based upon investment banking revenues or from the
subject company in the last 12 months.
• Jackson Securities has not in the last 12 months managed or co-managed a public offering of securities, received
compensation for investment banking services from the subject company or any compensation for products or
services other than investment banking
• Jackson Securities does not expect to receive or intend to seek investment banking compensation from the
subject company in the next 3 months.

Position as Officer or Director:

Neither the research analysts nor members of their immediate households occupy positions as an officer or director with
the company/companies mentioned in this report.

Market Making:
Jackson Securities does not make a market in this stock

Explanation of Ratings:
Buy - Expected 12-month absolute performance of +10% or higher than the market price at which time the rating was
issued.
Hold - Expected 12-month absolute performance of +5% to –5% from the price at the time the rating was issued.
Sell - Expected 12-month absolute performance of –10% or lower than the market price at which time the rating was
issued.

Distribution of Ratings:
Jackson Securities, LLC has a distribution of ratings among its coverage universe as follows:

Buys – 54.6% (18 of 33 active recommendations)

Holds – 42.4% (14 of 33 active recommendations)
Sells – 3.0% (1 of 33 active recommendations)

Jackson Securities has provided investment banking services within the previous 12 months with the following percentage
of the companies they have rated:

Buys – 3.0% (1 of 33 active recommendations)

Holds – 0% (0 of 33 active recommendations)
Sells – 0% (0 of 33 active recommendations)

Risks: General economic conditions, economic slowdown/recession, adverse industry news.

Other Important Disclosures and Disclaimers

Disclaimer: This communication is neither an offer to sell nor a solicitation of an offer to buy any securities mentioned
herein. This material should not be construed as an offer to sell or the solicitation of an offer to buy any securities

Brian Bolan
Director of Equity Research – Technology
mentioned herein in any jurisdiction where such an offer or solicitation would be illegal. We are not soliciting any action
based on this material. This document is for general information only, and it does not constitute a personal
recommendation or take into consideration the particular investment objectives, financial condition or financial needs of
any clients. Before acting on any advise or recommendation in this research report, clients should consider seek
professional advice. Past performance is not a guide to future performance. Future returns are not guaranteed, and a loss
of original capital may occur.

The information contained herein has been obtained from sources that we believe to be reliable, but we do not guarantee
its accuracy or completeness. Any opinions expressed herein are statements of our judgment on the date appearing on
this material only and are subject to change without notice. We endeavor to provide updates on a reasonable basis of the
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Brian Bolan
Director of Equity Research – Technology