Are Diamonds an Investor's Best Friend?

As the world's biggest online diamond retailer, Blue Nile (NAS: NILE) should be shining for investors. The company cuts overhead costs by selling on the Internet, and it waits to buy the rocks until after customers make a purchase. This contrasts with Zale (NYS: ZLC) , which operates jewelry chains, buys its diamonds in advance, and can sit on the inventory for months before making a sale.

Despite its inherent strengths, Blue Nile lost its sparkle in recent quarters. Last week, the stock was hammered after the e-tailer unveiled disappointing earnings for its fourth quarter. Net income fell 32% from a year ago, with earnings of $0.30 a share for the period. Analysts had expected $0.42 a share. Sales were hurt by increased marketing costs and weakened demand for engagement diamonds. As a result, the stock took a beating. However, shares still trade at a rich 43 times this year's earnings.

An indecent proposal
As an investor, you hope that negative results spur positive action. Unfortunately, Blue Nile's new plan could be destined for disaster. Blue Nile will further reduce prices in an effort to grow sales. This mimics the desperation of Aeropostale (NYS: ARO) , a company that has to slash prices across its retail locations in order to get clothes off the shelves. The problem is that these discounts quickly eat into margins and can really drag on a bottom line. I'm afraid the same thing will happen to Blue Nile.

Blue Nile hopes that by offering lower prices it will increase its customer base. Still, I'm not sure this would matter much because most of Nile's engagement shoppers are one-time customers. Blue Nile creates a positive experience for its customers by educating them on a diamond's quality characteristics and encouraging customers to build custom engagement rings. But the problem with the bridal business is that you don't get the repeat business that you would as a jeweler like Tiffany (NYS: TIF) , which has popular offerings outside of engagement sales. Blue Nile generated net sales of $333 million in 2010, compared with Tiffany's net sales of $3.1 billion for the same period.

In the past year, Blue Nile has lost nearly half of its value. The company's prices are already among the lowest. Compared with other online diamond retailers such as James Allen and, a one-carat diamond with similar color, clarity, and cut will cost you $12,790 from James Allen, $6,115 from Diamonds, and just $5,865 from Blue Nile. Slashing prices further will hurt already low margins, which I believe will stall growth in the long run.

Take a stand
I love the convenience of online shopping, and I believe in Blue Nile's business model. But I'm concerned about management's new pricing strategy coupled with its commitment to boost ad spending. For these reasons, I'm giving the stock an underperform rating in my CAPS portfolio in Motley Fool CAPS. As an investor, I encourage you to track these stocks by adding them to your watchlist. In case you're not familiar, My Watchlist is a free tool that lets you track and monitor your favorite stocks. Sign up for the free service now and you will also receive a special free report from The Motley Fool's top analysts -- click here to get started.

At the time this article was published Fool contributor Tamara Rutter owns no shares of the companies mentioned. For more investing news and Foolish insights follow her on Twitter, where she uses the handle: @TamaraRutterMotley Fool newsletter services have recommended buying shares of Blue Nile. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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