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The Blue Nile/Diascience Corp. (Yehuda Diamonds) Legal Battle Heats Up
By Please Act Accordingly

11/2/2009
In our original report on our pair trade idea: long Signet (SIG 26.69 ↑2.30%) Jewelers/short Blue Nile (NILE 57.77 ↑2.09%), we highlighted the risk that a lawsuit against Blue Nile could pose to the company. Earlier this year, Diascience Corp., (aka Yehuda Diamonds) filed a lawsuit against Blue Nile alleging that the company’s website: “does not disclose for each and every specific gemstone offered for sale whether that gemstone has been subject to clarity treatment/enhancement or what that clarity treatment/enhancement is”. Diascience Corp. alleges that gemstones sold on bluenile.com are in fact enhanced. These are serious allegations. We are not qualified to speak to their veracity of the allegations, but the plaintiffs claims could be highly damaging if true. Modified gemstones are worth considerably less than those that are without enhancement. We think the suit could create significant risk for Blue Nile. Trust in your jeweler is absolutely essential. Blue Nile has differentiated itself from its other web-based competitors through the price point it offers consumers and the trust it has established with its client base. In many respects, the consumer is buying the jeweler, not the stone. We think consumer trust in Blue Nile could be significantly impaired to the extent that details about the suit gain traction in the media, or a ruling is eventually made against Blue Nile . Jury Rules Against Blue Nile in Suit Against Yehuda Diamonds Yehuda Diamonds issued a press release today touting its recent legal victory over Blue Nile in a separate suit. You can read the full release here. Blue Nile had followed a separate suit against Yehuda Diamonds seeking damages of $60 million. Blue Nile alleged that Yehuda Diamonds used false and misleading advertising when it compared the price of its clarity enhanced diamonds to those sold by Blue Nile. The suit was dismissed by a jury in the state of Washington. Now that Blue Nile’s suit against Yehuda Diamonds has been dismissed we expect the focus to return to Diascience Corp (Yehuda Diamond)’s suit against Blue Nile. The suit is now in the discovery phase. That portion should be completed by the end of this year. Blue Nile shares could witness increased volatility if the suit goes to trial, or a settlement is reached. We continue to view long Signet Jewelers/short Blue Nile as a compelling pair trade idea. We view Signet Jewelers as the best investment vehicle in the specialty jewelry space based on its strong geographic footprint, well known brands, and growing web presence which has enabled the company to gain significant market share in the downturn. Additionally, the company is effectively long gold, silver, platinum and diamonds, which should lead to margin expansion in an inflationary environment. For Blue Nile, we think shares could see considerable downside if the Diascience Corp. lawsuit escalates. Additionally, we think the fundamental short thesis is equally compelling: 1) the company has a significant operating margin conundrum, it is promotional in a downturn and squeezed by higher commodity costs in an upturn, and 2) the company will face increased competition from more sophisticated web-retailers (AMZN (119.42 ↑1.98%)) and established onsite specialty jewelers that are expanding their web-presence. Clearly, these concerns are not yet embedded in the valuation of NILE shares. The stock now trades at 71.6x consensus FY09 EPS and 56.8x consensus FY10. We see downside in NILE shares towards $30 if investors embrace some of the fundamental flaws in NILE”s business model and/or the Diascience lawsuit creates a substantial amount of negative publicity. As always, please act accordingly….

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