Blue Nile Diamonds Losing Luster

Mar.25.10 | About: Blue Nile, (NILE)

For the last few months, the market has continued to push to new recovery highs, and the Retail HOLDRS (NYSEARCA:RTH) have actually been exhibiting leadership and outperformance. Now a day does not a trend make, but Wednesday’s action was interesting as the RTH declined by 0.92% while the S&P 500 was only down 0.55%. I understand this is only one data point and may turn out to be insignificant, but today could turn out to be the day the retail sector turned.

Blue Nile Inc. (NASDAQ:<a href='' title='Blue Nile, Inc.'>NILE</a>)While I don’t have extreme confidence in calling a top for retail, I am developing a healthy dislike for the way Blue Nile Inc. (NILE) has been trading. In early November, ZachStocks covered Blue Nile’s earnings report, noting that international sales were growing more quickly than domestic revenue (although international revenue only represented about 13% of total sales). Despite the relatively healthy earnings report, we noted that the stock could easily be trading at double its reasonable value – and laid out the case for initiating a short position.

As of the close Wednesday, the stock has dropped about 14%, but the negative outlook is still just as dire as ever. Analysts are expecting the company’s earnings to grow by 21% this year to reach $1.02 per share, and then in 2011 the expectation is for $1.23 in earnings. I’m not sure that we can place much confidence in these numbers given the uncertainty due to unemployment and the potential “re-destruction” of wealth as adjustable mortgages reset and US taxpayers foot the bill for the new healthcare plan.

But assuming these analysts are accurate in their assessment, please explain why the stock is trading at roughly 53 times next year’s earnings! This is a very aggressive price even for a company growing rapidly like Crocs Inc. (NASDAQ:CROX) back in 2007. But for a company like NILE with 20% growth expected over the next two years, the multiple seems absurd.

Over the past week, NILE’s chart has featured a pattern which many technicians call the “death cross.” This pattern occurs when the 50 day moving average crosses below the 200 day average. Now I don’t think there is any magic in these moving averages, but they do offer an excellent way to graphically illustrate the pattern that is evolving. After spending a significant amount of time in a positive trend, the stock has finally begun to falter and at this point the short-term average of its daily closing price is below the long-term average – that simply means the tide is turning and the prevailing trend is negative.

Now while I said I don’t place too much credence in the actual pattern (I’m looking more carefully at the concept), there are traders who will swear by the patterns and make their trades like clockwork based on special indicators like the “death cross.” As traders we have to respect this action and understand that a significant amount of selling pressure could quickly hit the stock. At this point with a series of lower highs and lower lows, we could quickly see momentum pick up and NILE could be in the 30’s or even 20’s by mid-summer.

One thing to be careful of is that Blue Nile has been a big target for other short-sellers. Currently the published amount of short exposure is 14% of the float. It would take 15.5 days of trading (using the average daily volume) for these short sellers to exit their position. The danger in this statistic is that if something positive is announced and the stock begins to move higher, the shorts could quickly hit the exits all at once, driving the price higher in a short period of time.

So fundamentally and technically, this looks like a good short opportunity with the potential for 40% to 50% profits. However, the risk is certainly present so position sizing should be appropriate and traders should always use a stop-loss when holding short positions.

Blue Nile Inc. (<a href='' title='Blue Nile, Inc.'>NILE</a>)Click to enlarge

Full Disclosure: Author does not have a position in NILE