Blue Nile: All Sparkle, No Substance?

To say Blue Nile is its industry's leader is an understatement, given it's the lone online-only jewelry retailer that's profitable and debt-free. And Blue Nile (NILE) sells more jewelry online than any retailer -- about a third of Web jewelry sales.

The Seattle-based company is expected to earn 75 cents a share in the fiscal year that ended December 5, 2005. That's a 34% jump in earnings per share from the previous year. Plus, by beating earnings estimates in its second and third quarters last year, the company has seen its stock soar.

Sound strategy. Blue Nile's strategy is to steal market share from national brick-and-mortar jewelers by under-pricing them. The firm has two key pricing advantages: It cuts costs by buying diamonds only after customers pay for them. It also has contracts with diamond wholesalers that give it exclusive right to sell their stones online at volume-pricing discounts.

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Blue Nile's biggest potential pursuer is also a potential suitor, namely, Amazon.com. The Web behemoth began selling loose diamonds in 2005, debuting a diamond-shopping Web site that's as easy to use as Blue Nile's. But Amazon's diamond jewelry business has two flaws: Amazon lacks Blue Nile's inventory and its phone-based customer service, featuring representatives trained to answer gemological questions.

Might Amazon buy Blue Nile? Geography certainly isn't an issue. Blue Nile's corporate office is located on the ninth floor of a building otherwise owned and occupied by Amazon. Legg Mason senior analyst Scott Devitt, who covers both companies, says they'd be a good fit financially.

Amazon.com could try to steal Blue Nile's contracts. But Blue Nile CEO Mark Vadon says he isn't worried. Vadon notes that none of Blue Nile's wholesalers has failed to renew a contract, and Blue Nile has accommodated the wholesalers in a variety of details, which rival retailers would have trouble duplicating.

Blue Nile has impressed us on a tour of its facilities. The company has a culture of innovation and cost-cutting that is noticeable from the electronic monitors on the walls of its call center (which measure the average time it takes a customer to reach a sales representative) to clever refinements in how the company has had itself listed in online search engines. These strategies contrast with the Old World ways of traditional jewelers, giving Blue Nile an advantage when stealing market share.

Blue Nile's good business plan, competitive position and strong earnings have pushed the stock up to around $41 a share. That translates into a price-to-earnings ratio 42 times the 99 cents per share that analysts see the company earning in its fiscal 2006 year, according to Thomson First Call.

Analysts are tepid. That's a pricey valuation, and analysts generally don't see future earnings increases keeping pace. Sales of high-priced jewelry online is a new phenomenon, and the pace of such online sales growth is difficult to predict.

The best investment in Blue Nile at the moment is buying its jewelry, not its stock. But should the stock price dip, or if you have a spot in your portfolio begging for a small growth company with some risk, Blue Nile is a good prospect.

-- Sean O'Neill