Is Blue Nile Losing Its Comparative Advantage?

Last week Blue Nile (Nasdaq: NILE  ) reported earnings that many analysts had predicted would be stellar. Instead, the company limped through the quarter and forecast earnings and revenue which were below consensus estimates. It seemed everyone was surprised by this sudden turn of events -- but not me.

As a longtime Motley Fool Rule Breakers pick, Blue Nile has treated shareholders well and I'm sure they'd argue it will continue to treat shareholders well -- the company did guide to double-digit earnings growth in 2011. But what defines the "motley" in Motley Fool is diversity of opinion...and you're about to get a-heaping of it.

Anything you can do, I can do better
Blue Nile's sole advantage over brick-and-mortar mall retailers like Zale (NYSE: ZLC  ) , Signet Jewelers (NYSE: SIG  ) , and Tiffany (NYSE: TIF  ) , is that it has lower overhead costs. Without having to spend millions on purchasing diamonds for inventory and risking that the merchandise just sits in a display case, the company can instead choose to market considerably more diamonds by posting lists of available stones online. Once a customer has made their diamond selection, Blue Nile simply purchases the diamond of choice from its vendor, and ships the diamond. In theory, Blue Nile should be able to undercut the aforementioned mall-retailers on price and win over customers.

Lately, however, this plan has gone awry, and here's why:

Mark-to-market, diamond-style
Commodity and labor costs are skyrocketing. Sure, you've seen gold and silver prices rising, but did you ever stop to think what might be going on in the diamond market or with labor costs? Diamond prices are at new highs, surpassing the levels we saw in 2008, and labor costs to mine and set diamonds are rising worldwide. This isn't a problem for B&M retailers that have negotiated deals to purchase diamonds outright, but it presents a major problem for Blue Nile.

Blue Nile only purchases a handful of its diamonds, so when a customer decides on a purchase, it's very likely that Blue Nile is going to have to pay the current high market price for that diamond. Blue Nile was built on the assumption that its low overhead would allow it to undercut its rivals, but rapidly rising commodity prices cut into its business plan. Now it seems the playing field is much more level, and Blue Nile now doesn't have the comparative advantage it once possessed.

The same goes for rising gold prices. Blue Nile began carrying diamond mountings a few years ago, and like I mentioned regarding all jewelry retailers, $1500 gold is generally bad news. Higher gold prices mean smaller margins and fewer shoppers. As gold trickles higher, it prices potential consumers out of the market.

Flawless? I think not
It remains to be seen if my opinion will hold water in the coming quarters, but the facts are there and last week's earnings warning was just more fuel for the fire that this stock isn't flawless after all.

Is Blue Nile a diamond in the rough, or does it have cubic zirconia stamped all over it? Share your opinion in the comments section below and consider tracking Blue Nile as well as your own list of companies with My Watchlist.

Fool contributor Sean Williams has no material interest in any companies mentioned in this article. He would like to remind you not to forget about our friends in Japan who could still use a helping hand. You can follow him on CAPS under the screen name TMFUltraLong. Blue Nile is a Motley Fool Rule Breakers pick. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy that's flawless.


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