Dueling Fools: Blue Nile Bull

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The worry of being fleeced by a salesperson looking to pull one over on us is fairly common. And probably for good reason -- I'd be quite interested to know, for example, the markup that a young Kobe Bryant paid for a $100,000, 7-carat diamond engagement ring that he reportedly purchased from Zale (NYSE: ZLC) back in 2000.

That leery attitude toward salespeople is one reason I'm not surprised that Rule Breakers pick Blue Nile (NYSE: NILE), an online jeweler, has been able to step in and make a major splash in fewer than nine years -- and only four of those years as a publicly traded company. The customizable experience on Blue Nile's website has been instrumental in the company's operating success and the corresponding run-up in the stock price.

Although it has been discontinued as a recommendation at Motley Fool Hidden Gems, Blue Nile has returned investors 117.8% so far this year, 160.2% since it was originally picked as a Rule Breaker in October 2004, and an astounding 202.2% since it was introduced as a Hidden Gems pick in August 2005. What's striking, aside from this impressive run, is how the company has been able to achieve its success. When compared with some of its well-known competitors, such as Zale, Tiffany (NYSE: TIF), and Birks & Mayors (AMEX: BMJ), Blue Nile's gross margin appears to put the company at a decisive disadvantage.

Company	Gross Margin (Trailing 12 Months)
Blue Nile	20.2%
Zale	51%
Tiffany	55.3%
Birks & Mayors	48.1%

Source: Capital IQ, a division of Standard & Poor's.

Yet that's been anything but the case. Without the same overhead burden that most of its traditional peers face, Blue Nile has been able to efficiently run a business that has achieved a market cap of $1.3 billion with only about 160 employees. What's more, the company has not only been able to undercut the competition on price, but it has also been able to neutralize the effect of its slimmer gross margin thanks to a controlled spending approach. Its selling, general, and administrative expenses as a percentage of net sales are markedly lower than those at Zale, Tiffany, and Birks & Mayors, and this statistic goes to the heart of Blue Nile's business model of stealing away market share.

Company	SG&A % of Net Sales (Trailing 12 Months)
Blue Nile	13.5%
Zale	43.7%
Tiffany	39.1%
Birks & Mayors	39.5%

Source: Capital IQ.

Now that the stock trades at a forward price-to-earnings ratio of around 61, there have been some rumblings that it's becoming a victim of its own success and could now be overvalued. This concern is somewhat understandable, but given the company's recent earnings growth and its outlook, I don't believe this is the case yet. The opportunity cost that one would be giving up by passing over Blue Nile is too steep.

For its second quarter, Blue Nile checked in with operating income that rose 39% year over year. Net sales rose 26.7% in Q2, and the company upped its full-year forecast for diluted earnings per share to a range of $0.94 to $0.99, which would be a 27% improvement over its fiscal 2006 numbers. Investors should also keep in mind that the company has exceeded Wall Street's forecasts over the past six quarters, so I would be not at all surprised if the company closes out the year above this range.

As the holiday season approaches, the contrarian investor who is willing to accumulate shares of Blue Nile in the wake of valuation concerns stands to be generously rewarded, should the company once again exceed expectations in what is typically its busiest quarter of the year. The Hidden Gems team has taken its profits on this one, but I think that decision could prove to be premature. In terms of growth, the Rule Breakers team appears to have my back on this position.

You're not done with this duel yet. Read the other three parts, and vote for a winner!