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Bargain hunters may be tempted to take a look at Blue Nile, Inc. (NASDAQ:NILE) which is down roughly 75% from last year's high. After all, the company has no debt and posted third quarter profits, as opposed to many retailers which showed losses. The company actually saw sales come in near the same levels as last year, which has some bulls optimistic that stability will remain with this diamond retailer. ZachStocks’ readers will note previous cautionary articles on Blue Nile, and have hopefully sidestepped the carnage.

Looking more closely at the company’s earnings release, it is clear that trends are souring - and quickly. In a press release from early November, management stated that the holiday season would be challenging. October sales were down 20% from last year, and that doesn’t account for the typical holiday rush that will likely be inferior to 2007 levels. In a sign of the times, Blue Nile has for the first time in its public history, declined to offer guidance for the coming quarter. Diane Irvine, CEO, stated that the environment was simply too challenging to give investors a reasonable expectation for sales during the third quarter.

In an interview with Investors Business Daily, Ms. Irvine stated that the primary challenge is a lack of available credit for the company’s customers. The bulk of NILE’s sales comes through credit card purchases. That is certainly a difficult obstacle considering the fact that most card issuers are pulling back limits on outstanding cards and declining to issue new cards to potential buyers. Blue Nile actually offers third party financing on its website, but has seen approval rates drop due to tighter credit standards.

The typical NILE customer is a 25 to 35 year old male purchasing an engagement ring. Unfortunately, this is one of the hardest hit demographic categories. At this time the typical buyer is opting for a smaller diamond, a less sophisticated band, and in general, a lower priced item. Bullish investors have long argued that the jewelry business caters to the wealthy and affluent, and should be relatively immune to an economic downtrend. But since NILE focuses on the lower-end engagement type jewelry, the company’s customers are actually very sensitive to economic cycles.

As I write, the stock is trading in the low 20’s with 2009 earnings expected at $0.90 per share. Now, I understand that these expectations could change significantly over the next year, but a multiple above 20 seems unrealistically optimistic in my opinion. The company should survive as an ongoing business due to its low cost structure and sound financial footing. However, earnings will not likely rebound sharply as consumers will continue to be careful with spending even once the economic cycle begins to turn.

Some may expect inflation to help the jewelry business out as inventories will likely rise as the purchasing power of the dollar declines. However, RBC had an excellent research report which, among other issues, pointed out that inflation would actually disadvantage NILE. The reason is that the company holds a relatively low level of inventory so inflation would increase costs just about as fast as it increases sales prices. Margins would likely remain stable, thus offering little help to a troubled retailer.

Despite the lower stock price, I would continue to urge caution and steer investment capital away from this name. There may be a period where the value in NILE shares becomes compelling. But at well over 20 times expected earnings, I believe the risk far outweighs the potential gain.

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NILE Notes

Disclosure: Author does not have a position in NILE.

Source: Blue Nile: Diamonds Are Not Forever