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Blue Nile Appears Highly Overvalued

Blue Nile’s stock (NILE) initially traded higher after reporting Q3 numbers at the beginning of November. While revenues were a bit disappointing (only meeting analysts' expectations), earnings were above estimates and 64% above the earnings from Q3 of 2006. Management was very upbeat on the conference call and even increased their 2007 guidance for both sales and earnings. Management now expects sales of $109 to 115m for Q4 and earnings of $0.40-0.45 leaving us with a full year 2007 number of $1.00 to $1.05.

While the headlines read “management raises guidance,” the fact is that the strength was largely in the third quarter and guidance for Q4 is not that impressive when comparing it to Q4 of 2006. If earnings come in at the top end of the range, it will represent a 15% increase annually which is far slower than its growth of previous quarters. While 15% growth is attractive, it hardly justifies a multiple of 70+ times current earnings which is where the stock is trading right now.

Digging into the conference call, I noticed that management stated much of the strength was from its international sales which were up an astounding 105% year over year. This sounds great until one realizes that the company re-launched its two international websites this year so of course the percentage gain would be significant given the anemic base international sales were starting from. While this could definitely be an area for the company to explore for growth, the numbers are fairly light at this point and there is little evidence that an international push is really gaining traction.

The company is flush with cash. Cash levels have risen to a point where there is $4.40 per share sitting in the bank. While Blue Nile has re-purchased shares in the past, analysts were surprised to note that this is the second quarter in a row that the company has not repurchased a single share. When asked about this fact, management said they would not be averse to using cash for share repurchases but wanted to wait for a more opportune time. This implies that management views the stock as at least somewhat overvalued and is holding their cash until they are able to employ it at lower price levels.

As mentioned, valuation is extremely high for the growth rate currently being observed. This is certainly no reason outright to short the stock, but the price pattern is shaping up to confirm what the fundamentals are saying. It would have been foolish to short NILE in the 70’s this summer as momentum was strong and traders continued to bid up the shares. But as we transition to a market that is showing weakness, and consumers are showing more signs of fatigue, NILE’s stock has begun to weaken and was not able to participate in the recent market strength. This is a telltale sign that institutions are not accumulating shares and serves as a red flag to anyone long this retail name.

Investors will likely be disappointed with the Q4 numbers and in the meantime, bad general data points for consumers should carry weight for this stock in particular.
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