There's no question about it -- Blue Nile (NASDAQ:NILE) is establishing itself as a great online destination for buying diamonds and jewelry. It's a solid company with a low-cost business model. Just as importantly, it has a very strong reputation for quality and honest dealing, which is essential for selling high-price trinkets like diamonds sight unseen.

Yet in spite of the company's obvious strengths, I see three reasons to worry about investing in Blue Nile right now: valuation, competition, and the economy. There's often a huge gap between a great company and a great investment, and right now Blue Nile looks like a clear-cut example.

Economic woes
The problem with diamonds in particular is that purchases are very economically sensitive. Sure, people will still get engaged during a recession, but they probably won't have the same propensity to shell out top dollar for a perfect stone.

For instance, the difference between an "Internally Flawless" diamond and a "Very Very Slightly Included" one (as the industry lingo goes) is usually not visible to an untrained observer. Likewise, only a pro can tell the difference between a "D" color and an "F" color diamond, and the difference between an "Ideal" cut and a "Very Good" cut is only a very small amount of sparkle. And what casual observer can truly tell the difference between a 0.99-carat diamond and a 1.01-carat one?

Yet looking at Blue Nile's site, a 0.99-carat, Very Good cut, F color, VVS2 clarity diamond sells for $6,649, and a 1.01-carat, Ideal cut, D color, Internally Flawless stone goes for $18,273. That's a pretty substantial difference in price for differences that are largely unnoticeable to folks in the real world. When the going gets tough, people will still get hitched, but I seriously wonder how many people worrying about their jobs will spring for the more expensive rock.

Speaking of cost differentials, I don't see much difference between this watch from (NASDAQ:AMZN) and this one from Blue Nile. They're both the same model (Kenneth Cole KC2414), but the one from Amazon is 25% cheaper. I understand that people are willing to pay a premium to buy from a name they trust, but Amazon's retailing reputation is at least as strong as Blue Nile's.

Among jewelry stores, Tiffany (NYSE:TIF) is about the only one that's able to reliably and consistently charge premium prices. Blue Nile, on the other hand, built its reputation on undercutting the competition. Yet when shopping for my wife's engagement ring a few years ago, I found a much better deal in person at EDB's Diamond Showroom than I did online at Blue Nile. If customers can find lower prices on diamonds through factory-direct local channels and better prices on other jewelry at Amazon, why should they continue shopping at Blue Nile?

Then there's the small problem of the huge premium that investors are paying to own Blue Nile's stock. As the chart shows, the industry titans are all available far more cheaply than Blue Nile is. Even more of a worry is that even its smaller competitors can be bought at lower prices relative to their book values and earnings.


Trailing Price-to-Earnings Ratio

Price-to-Book Ratio

Trailing-12-Month Revenue (Millions)

Birks & Mayors (AMEX:BMJ)




Signet Group (NYSE:SIG)
















Blue Nile




Source: Yahoo! Finance.

When a company trades at such a premium to its competition, it's a sign that the market already expects great things from it. That certainly seems to be the case for Blue Nile. As a result, it has that much higher of a hurdle to leap merely to justify its current valuation, much less continue to show its investors positive stock returns.

Better opportunities elsewhere
Considering the risks to its business model from a recession, the emergence of lower-priced competitors, and its very high valuation, I see no real reason to own Blue Nile stock right now. It's simply way too easy to find better values for your investing dollar elsewhere while waiting for the shine around Blue Nile's stock to fade.

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

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.