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Are Diamonds an Investor's Best Friend?

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As the world's biggest online diamond retailer, Blue Nile (Nasdaq: NILE  ) should be shining for investors. The company cuts overhead costs by selling on the Internet, and it waits to buy the rocks until after customers make a purchase. This contrasts with Zale (NYSE: ZLC  ) , which operates jewelry chains, buys its diamonds in advance, and can sit on the inventory for months before making a sale.

Despite its inherent strengths, Blue Nile lost its sparkle in recent quarters. Last week, the stock was hammered after the e-tailer unveiled disappointing earnings for its fourth quarter. Net income fell 32% from a year ago, with earnings of $0.30 a share for the period. Analysts had expected $0.42 a share. Sales were hurt by increased marketing costs and weakened demand for engagement diamonds. As a result, the stock took a beating. However, shares still trade at a rich 43 times this year's earnings.

An indecent proposal
As an investor, you hope that negative results spur positive action. Unfortunately, Blue Nile's new plan could be destined for disaster. Blue Nile will further reduce prices in an effort to grow sales. This mimics the desperation of Aeropostale (NYSE: ARO  ) , a company that has to slash prices across its retail locations in order to get clothes off the shelves. The problem is that these discounts quickly eat into margins and can really drag on a bottom line. I'm afraid the same thing will happen to Blue Nile.

Blue Nile hopes that by offering lower prices it will increase its customer base. Still, I'm not sure this would matter much because most of Nile's engagement shoppers are one-time customers. Blue Nile creates a positive experience for its customers by educating them on a diamond's quality characteristics and encouraging customers to build custom engagement rings. But the problem with the bridal business is that you don't get the repeat business that you would as a jeweler like Tiffany (NYSE: TIF  ) , which has popular offerings outside of engagement sales. Blue Nile generated net sales of $333 million in 2010, compared with Tiffany's net sales of $3.1 billion for the same period.

In the past year, Blue Nile has lost nearly half of its value. The company's prices are already among the lowest. Compared with other online diamond retailers such as James Allen and, a one-carat diamond with similar color, clarity, and cut will cost you $12,790 from James Allen, $6,115 from Diamonds, and just $5,865 from Blue Nile. Slashing prices further will hurt already low margins, which I believe will stall growth in the long run.

Take a stand
I love the convenience of online shopping, and I believe in Blue Nile's business model. But I'm concerned about management's new pricing strategy coupled with its commitment to boost ad spending. For these reasons, I'm giving the stock an underperform rating in my CAPS portfolio in Motley Fool CAPS. As an investor, I encourage you to track these stocks by adding them to your watchlist. In case you're not familiar, My Watchlist is a free tool that lets you track and monitor your favorite stocks. Sign up for the free service now and you will also receive a special free report from The Motley Fool's top analysts -- click here to get started.

Fool contributor Tamara Rutter owns no shares of the companies mentioned. For more investing news and Foolish insights follow her on Twitter, where she uses the handle: @TamaraRutterMotley Fool newsletter services have recommended buying shares of Blue Nile. 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.

Read/Post Comments (6) | Recommend This Article (2)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On February 21, 2012, at 3:25 PM, markzommer wrote:

    If is able to sell diamonds at double the price Blue Nile can, my vote is to invest in James Allen.

    Generaly speaking, diamonds are cheaper at than they are on BlueNile and here is an example:

    The diamond for $5,865 the article is referring to on BlueNile is G in Color, SI2 in Clarity Excellent Cut and Excellent Symmetry. The Polish however is Very Good which downgrades the overall make of the diamond.

    A comparable diamond on is $6,050 and the Polish is Excellent which means the James Allen stone is better cut.

  • Report this Comment On February 22, 2012, at 11:32 AM, truthdiamonds wrote:

    Everything @markzommer said was 100% spot on. I discuss why Blue Nile is failing so miserably in this post on my blog, Truth About Diamonds:

    Tamara, you should read it and get in touch with me to learn what's really going on with them.

    Go Canes!

  • Report this Comment On February 22, 2012, at 2:18 PM, stuckinamobile wrote:

    Hello? Put down the free otions on NILE you receive and get real. Review the management history NILE. Five CEO's in three years? The onlyt thing they did for NILE was insiser sales. Look at the option and sale history of the last CEO that just walked away one day. How about the regular decline in quarterly numbers and then the bad mis this quarter? This stock is priced like a growth stock and the numbers continue to decline. Business modle? What business modle? People spending thousands on a diamind do not want a cheap diamond, they want a quality diamond from a trusted company. NILE is not a trusted name and will continue to decline as the press on NILE continues to decline.

    This stock is over double the price it should be trading. It is nothing more then a middleman seller and trades at an outrageous valuation for a company that is nothing more than a web site with no inventory and no assets. They are trying to sell lower priced items to keep up the sales but it kills the profit line. Now they want to lower prices in a market where their whole dales costs for diamonds and metals keep rising. Diamond prices are up 75% in the last 6 years. This is a company in trouble and for you to continue to pump it up tells me you must be working with the crooked funds and institutions that control the float and manipulate the trading price.

  • Report this Comment On February 23, 2012, at 10:36 PM, TMFUltraLong wrote:

    I more of less agree with the basic premise here because it's the same opinion I've had on Blue Nile for more than a year.

    The "only" thing I'd like to add, having worked in the jewelry business for a decade and having degrees from GIA in diamond grading, is that cuts are not night-and-day comparisons. Polish, symmetry.... it's all apples and oranges until you can see that diamond in person. Light performance matters more than anything and its veritably impossible to get a company to be upfront with this aspect of a diamond - let alone have the proper tools or training to correctly identifiy the quality of the cut grade based on light performance.

    Blue Nile has simply lost its comparative advantage. Commodity, labor and marketing costs are rising faster than they can keep up with. There's advantages and disadvantges to carrying little inventory - and right now it's hurting Blue Nile.

  • Report this Comment On May 29, 2012, at 4:20 AM, jimwhite12 wrote:

    I agree with the general view as well. The point here is that Bluenile has fallen behind it's competitors in terms of support and technical aspects of buying a diamond.

    While other prominent sites had already incorporated technology like virtual loupes as well as diamond analysis data, Bluenile lacks far behind in this aspect and rather, focuses on their "dropship" mindset.

    This is causing concerns in helping potential customers in <a href=" a diamond</a>.

    If it doesn't change that mindset, chances are, we will see more slips.

  • Report this Comment On December 09, 2012, at 10:10 PM, jimwhite12 wrote:

    diamonds are bad investment choices unless you go big or go rare (colored stones). Otherwise, be prepared to take a loss (in trying to sell your stone) as soon as you pay for the diamond purchase.

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