Blue Nile Breaks Hearts

You know when you present something to your sweetheart for, let's say, Valentine's Day, and you realize by your loved one's expression that he or she was expecting much, much more? Well, it's not too hard to apply that analogy to Blue Nile (Nasdaq: NILE) after it reported earnings Tuesday. Now investors are left wondering whether to buy, bolt, or just sit tight. And right before Valentine's Day, too.

Blue Nile, which happens to be a stock recommendation for both Motley Fool Rule Breakers and Motley Fool Hidden Gems, reported that fourth-quarter net income increased 15.9% to $5.3 million, or $0.29 per diluted share, with sales increasing 13.5% to $73.2 million. Analysts were expecting something more along the lines of $0.33 per share in earnings and a 24% increase in sales. Ouch.

For the entire year, Blue Nile's sales increased 20%, and net income increased 31.7%. Free cash flow increased 8.2% to $30.2 million. It's important to note that Blue Nile has $114.8 million in cash and cash equivalents (excluding restricted cash), or about $6.60 per share, and no long-term debt. It has also been buying back shares.

While we may often choose to disregard the short-term fluctuations caused by companies missing analysts' overly optimistic estimates -- and Fool contributor Rich Smith pointed out in his Foolish Forecast that Wall Street had ambitious expectations -- the big bummer is Blue Nile's growth outlook for 2006. In fact, Blue Nile steered investors to expect earnings to come in about flat, with net income expected to come in at $0.62 to $0.72 per diluted share (including the estimated impact of expensing stock options, at $0.14 to $0.16 per diluted share). Blue Nile said that sales will come in at $220 million to $245 million.

It's hard not to ignore that Blue Nile didn't deliver what one might hope from the big holiday season quarter. Indeed, it turns out that there's a stumbling block that Blue Nile has to clear that came into play in the final stretch of 2005. Blue Nile said that online marketing costs have increased "significantly." Indeed, in the conference call, management said that paid search -- buying relevant keywords for search engine advertising -- is coming at too high a price. For example, Blue Nile said that its cost per click on Google (Nasdaq: GOOG) rose by 50% compared with the year before. The company said that the increased costs for paid search in the fourth quarter meant it was not able to drive as much profitable growth as it had previously expected. It went on to describe the online advertising market overall as being a bit "frothy" when it comes to bids for paid search -- Yahoo! (Nasdaq: YHOO) and Microsoft (Nasdaq: MSFT) also seek to benefit from paid search on their search engines.

Blue Nile is making it clear that it wants to keep its profitability intact by refusing to pay what it believes is too much for marketing and look into other, less pricey avenues by which it might be able to woo new diamond buyers to its site. Management said in its conference call, "We remain disciplined in our spending, in order to maintain profitability on new customers rather than to chase unprofitable growth, as some of our competitors have done."

To my way of thinking, Blue Nile has already managed to build itself a powerful, respected, and well-known brand for high-end jewelry, particularly in the engagement ring area, and that's no small feat for such a young company that's competing with old-school names like Tiffany (NYSE: TIF) and Zale (NYSE: ZLC). It has also been heartening that Blue Nile has had great success in squeezing more jewelry sales from repeat customers, a situation that continues now. Blue Nile said it saw strong year-over-year growth in higher-margin, non-engagement jewelry, with much of that fueled by repeat customers, and it's an area where the company believes there's strong growth potential.

Investors' current concern is understandable. After all, Blue Nile's growth forecast for the coming year doesn't make a purchase of its shares look so appealing at the moment. Then again, Blue Nile has done some revolutionary things in the past, and with its disciplined approach and solid management, I can imagine that Blue Nile may be having a temporary reversal of fortunes that it can overcome in the long term. That said, investors who take that point of view will have to endure slow going for the short term.

Blue Nile is a Motley Fool Hidden Gems recommendation, as well as a Motley Fool Rule Breakers selection. Microsoft is a Motley Fool Inside Value pick.

Alyce Lomax does not own shares of any of the companies mentioned.