A Small Jewel of a Company

Online diamond retailer (and Foolish treat) Blue Nile (Nasdaq: NILE) is losing some of the sparkle on its stock price today. Trading at $28.00, it is down 20%.

The stock has had a roller-coaster run since going public in May at $20.50 a share. The stock peaked at $41.70 in June and tumbled to $21.65 in August.

Today's third-quarter results should have been good news. Revenue was within company estimates, and earnings were $0.02 a share higher than company guidance. Better yet, the company maintained its fourth-quarter revenue target and upped full-year earnings guidance to $0.54 a share (52 times 2004 earnings).

So, what is tarnishing this jewel? It might be income taxes. Income before income taxes rose 18.5% -- very nice! Income after taxes fell 22.7% -- not so nice. Without any tax loss carry-forward to shelter income, the high-flying retailer had a difficult comparison.

Also of concern are gross margins, which declined from 22.1% to 21.7%. As fellow Fool contributor Nathan Slaughter pointed out, brick-and-mortar retailers such as Zale (NYSE: ZLC) and troubled Friedman's have gross margins of 52.9% and 47.7% respectively -- and Tiffany's (NYSE: TIF) leads the pack at 57.7%.

So, why isn't this light Internet business model producing better margins? One reason is size. Blue Nile is projecting 2004 revenue of up to $166.5 million. Trailing 12-month sales at Zale and Tiffany's exceed $2 billion.

Also, Blue Nile is aggressively growing its business, and it needs to be very competitive with prices. With the likes of Wal-Mart's (NYSE: WMT) Sam's Club and Costco (Nasdaq: COST) selling jewelry, Blue Nile must win customers based on quality and price -- two things it can do with its business model.

Consider what Blue Nile offers investors. It is the largest online retailer of certified diamonds and fine jewelry -- and, according to the company's website, it's larger than the next three online jewelers combined. So, Blue Nile is a category gorilla with three other advantages -- it is cash-rich, debt-free, and growing rapidly.

The stock's multiple is high. That's a reflection of the opportunity to grow quickly and expand margins. Investors sold on today's news, but today's stock price is a good entry point for those looking for a small jewel of a company that dominates its category and has the financial clout to deliver on its opportunities.

Blue Nile was an inaugural recommendation for Motley Fool Rule Breakers . Are you interested in strong companies with great growth opportunities? Take a free, 30-day trial today.

Fool contributor W.D. Crotty does not own stock in any of the companies mentioned.