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Blue Nile: A Holiday Engagement

The largest online diamond retailer is counting on big holiday sales. And for the long-term, its prospects look intriguing.

June is the traditional month for weddings, but for engagements, December takes the prize. One out of five engagements are said to occur in the last month of the year. Between all those engagements and regular holiday gifts, this is make-or-break time for diamond sellers in general and for Blue Nile in particular. Analysts figure that Blue Nile's fourth-quarter sales will approach $92 million, or 36% of total 2006 sales.

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Since its founding in 1999, Blue Nile has grown into the largest online retailer of diamonds and engagement rings in the U.S. Yet the Seattle-based company, which sold 27,000 engagement rings in 2005, estimates that it accounts for only about 3% of engagement-ring sales, which traditionally are made by mom-and-pop operations.

To draw customers out of jewelry shops and to its Web site, Blue Nile touts both its broad selection and the ability to customize rings. And because of special arrangements with its suppliers, Blue Nile can charge 20% to 40% less than brick-and-mortar rivals can.

The relationships with suppliers are key to Blue Nile's success, says Morningstar analyst Kimberly Picciola. Diamond manufactures agree to sell their loose diamonds exclusively through Blue Nile's Web site. But Blue Nile doesn't keep an inventory of stones on its books. Instead, the supplier generally ships a diamond to the retailer's warehouse after a customer places an order, and Blue Nile doesn't pay the manufacturer until well after the transaction is completed. "This leads to returns on invested capital that far exceed [the company's] cost of capital," says Picciola. The exclusive relationships with high-quality suppliers also give Blue Nile a leg up against the competition. Picciola expects the firm's earnings to grow 22% annually over the next five years, as it captures a larger share of the expanding business for online jewelry sales.

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Jordan Rohan, an analyst at RBC Capital Markets, thinks Blue Nile is well positioned to succeed. He upgraded the stock (symbol NILE) to "outperform" from "sector perform" on December 5. One reason: Skyrocketing Internet advertising rates that hurt Blue Nile's fourth-quarter earnings last year don't seem to be materializing this year. (The company earned 29 cents a share in the fourth quarter of 2005, below the 33 cents a share that analysts expected, and the stock plunged from $44 in November 2005 to as low as $24 last August.) Rohan also applauds Blue Nile for cutting prices slightly, a move that has prompted a greater percentage of customers who visit the site to make a purchase.

Rohan says that last year's earnings hiccup has led to a more realistic view of the company's prospects. Whereas last year many investors saw the company's business model as unassailable, he says, this year the company is considered simply "a well-run e-commerce company."

The stock, which closed at $34.92 on December 5 (up 3.6% for the day), is certainly not cheap. It sells for 38 times analysts' average 2007 earnings estimates of 92 cents per share, according to Thomson First Call. But considering the company's advantageous business model, debt-free balance sheet, and growth prospects, the stock could still yet sparkle.

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