Back in January, I named Blue Nile (NASDAQ:NILE) the best e-commerce stock for 2007. Today, I'm sticking in the knife.

Have I given up on the awesome Blue Nile customer experience? Have Tiffany (NYSE:TIF) or Zale (NYSE:ZLC) brought their comparatively greater resources to bear, entering the online space in force to eat Blue Nile's lunch? Has Blue Nile seen its much-vaunted business model of light assets and low working capital falter and grow bloated?

Not at all! In fact, I think any company that aspires to greatness should study and emulate Blue Nile's obsessive customer focus. Furthermore, I've seen no indication that the competition is any less comatose today than it was last year. And Blue Nile's financial model remains essentially unchanged.

What's spooked me? Actually, two things: the appalling valuation (though it's somewhat improved from the truly ghoulish levels it rose to in September), and signals on myriad fronts that management is scared, too.

Valuation station
When I wrote my January article, Blue Nile sold for $38 a share, so investors were paying 47 times earnings and 25 times my estimate of free cash flow. Those numbers aren't exactly cheap, but with the company growing the top line at 20% while seeing flat earnings getting goosed by repurchasing shares, there were worse overvaluations out there. Then Blue Nile turned in a couple of very nice quarters. Multiple analysts started shaking their upgrade pompons, and the valuation got positively horrifying. At its September height of $106 per share, Blue Nile changed hands at 122 times earnings and 57 times free cash flow.

Even today, at around $80, Blue Nile's stock trades at multiples nearly double those we saw in January. In other words, new investors today are paying nearly twice what they would have paid back then for every dollar of earnings or free cash.

Management's jumping out. Are you?
The other chilling development is the abandonment of the stock among key insiders -- and I speak not of the common practice of exercising options and selling the newly created shares. I mean honest-to-goodness fire sales of the prior ownership positions as the shares rose to the stratosphere. In other words, if you've bought Blue Nile recently, you may have bought it from one of the people in the table below:  

Blue Nile Insider


10/25/06 Holdings

10/25/07 Holdings

Change in Ownership

Mark Vadon

CEO and Chairman of the Board




Diane Irvine

President (former CFO)




Dwight Gaston

Senior Vice President




Susan Bell

Senior Vice President




Terri Maupin





*Includes indirect-ownership shares.

The exception to the mass exodus is Terri Maupin. But a closer reading of her transaction history shows that all of her shares have come from option exercises and that she's exercised and sold significantly more than she's held -- most literally, on the day the shares vest.

Some of these options have eight or nine years until expiry, so exercising and selling might be considered an irrational act, since Maupin has nearly a decade of potential appreciation remaining. Yet it's a perfectly rational act if one believes the shares overvalued. I get very concerned when the person closest to the money -- the controller -- exercises options and sells hand-over-fist. I had the same concern with Radyne (NASDAQ:RADN) in early 2006 as that stock sold above $16 a share while the controller was exercising and selling every barely-in-the-money vest option available, with years left until expiry. That stock now sells below $10.  

But the final nail in the coffin is that Blue Nile managers themselves, who had been active buyers of their own stock (nearly 2 million shares -- 11% of the total then outstanding -- in the 12 months ended March 31) abruptly ceased buying as the stock rose above $40.

The Foolish bottom line
I like Blue Nile, the company. But Blue Nile, the stock? Not so much. Buying the hype is a critical error you must avoid, and this is one stock to get scared out of. Let us know what you think in CAPS. Rate Blue Nile "underperform," or, if you disagree, rate it "outperform." Based on your responses, we'll declare the scariest stocks on Halloween.

Want to know what other companies give us the frights? You can view the rest of our hair-raising stocks here.

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.