If you've ever been shopping for an engagement ring before, you've probably received a helping-and-a-half of the 4 C's (cut, color, clarity, and carat weight), which explain why a diamond is worth what it's worth. Well let me tell you, based on what Blue Nile (NAS: NILE) reported last night, it must've been the cutters first day on the job because that report was ug-ly!

I have alluded on numerous occasions that I'm not a fan of Blue Nile and thought the business could be overvalued, but last night's earnings report only brought many of my concerns to light.

For the quarter, Blue Nile reported sales of $75 million and a profit of $0.13 per share which compares to the $72.6 million and $0.17 per share analysts had been looking for. Blue Nile pointed to a 55% jump in international sales as its strong point, but warned, as I also did recently, that rapidly rising diamond prices are crimping its margins. Perhaps more concerning, Blue Nile's fourth-quarter guidance and full-year profit outlook came in well-below the consensus with revenue guidance remaining unchanged.

Problem number one with Blue Nile is that it doesn't own very many of the diamonds that it's capable of supplying to consumers. This strategy of holding diamonds on consignment keeps its overhead costs low most of the time, but can really bite the company in the behind when diamond prices are shooting through roof, like they are now. Owning only a small selection of all diamonds available on their website, Blue Nile has been forced to pay steeper prices once a diamond is purchased, leaving them with the choice of either accepting lower margins or passing along these price increases to the consumer, negating the entire reason to buy online in the first place. Based on this report, it seems clear that Blue Nile has chosen the path of lower margins -- at least for now.

This isn't to say that Blue Nile's competitors are necessarily faring any better. Signet Jewelers (NYS: SIG) , Zale (NYS: ZLC) , Tiffany (NYS: TIF) , and even Wal-Mart (NYS: WMT) have had to pay higher prices for their jewelry because gold, labor, and gemstone prices are rapidly rising. But, these companies do share the fact that they own the majority of their jewelry, making it considerably easier for them to compete against Blue Nile on price recently. I hinted back in May that Blue Nile could be losing its comparative advantage and now that seems to be coming to fruition.

To add insult to injury, Blue Nile CEO Diane Irvine also resigned. The company didn't give any reason for her departure which can only add to the pessimism surrounding the stock today.

I can't speak for current shareholders, but if I were a shareholder, I'd be putting this stock back in the box from whence it came and slapping a large "return to vendor" note on the outside.

Will Blue Nile be the brick-and-mortar bringer of death or has the company reached its full potential? Share your thoughts in the comments section below and consider adding Blue Nile to your free and personalized watchlist to keep up on the latest news with the company.

At the time this article was published Fool contributor Sean Williams has no material interest in any companies mentioned in this article. A little-known fact: He is fully capable of grading a diamond. You can follow him on CAPS under the screen name TMFUltraLong, track every pick he makes under the screen name TrackUltraLong, and check him out on Twitter, where he goes by the handle @TMFUltraLong.The Motley Fool owns shares of Wal-Mart Stores. Motley Fool newsletter services have recommended buying shares of Wal-Mart Stores and Blue Nile, as well as creating a diagonal call position in Wal-Mart Stores. Try any of our Foolish newsletter services free for 30 days. We Fools don't 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 that's always looking for a diamond in the rough.

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pmbortz

As a jeweler I always knew that Blue Nile could never grow at the rates the market put on their multiple. First because independent jewelers can match prices and give more service and second because Blue Nile doesn't sell the sweetest diamonds.It was only a matter of time. They will have a business but it should be based on more conservative earnings.

November 09 2011 at 6:28 PM Report abuse rate up rate down Reply