What’s Shiny and Dropping Like a Rock?

There was a time when I was bullish on diamonds. I'd done a ton of research
into how DeBeers created a de facto monopoly on a shiny rock with no intrinsic
value, created the myth that diamonds were precious, and then destroyed any
competition. But times have changed. More and more diamond fields have been
discovered, DeBeers' grip on the market has been loosened, and the Internet
has made it easier than ever to buy and sell diamonds. While they aren't
exactly commodities just yet, things are very different in this market then they
were 10 years ago. I recently asked my local trusted diamond merchant to
appraise the same diamond he'd appraised for me in 1997. The number he came
back with was not much different. The issue with diamonds is that they are
intrinsically valueless. They have industrial uses and jewelry uses, but their
prices are driven by supply and demand Harry Winston Diamond (NYSE: HWD ) makes
beautiful diamonds. The company's stock, however, is 75% off its all-time high
in 2007, despite the fact that Winston owns a 40% stake in Canada's largest
diamond mine. You'd think that by owning part of a mine and being able to
fashion beautiful stones that the company would be doing great business. Yet
Winston had a loss in FY 2009 and was cash-flow negative that year and the year
before. This is the same reason I'm not crazy about Rio Tinto (NYSE: RIO )
which owns the other 60% of that Canadian diamond mine, among many others. The
difference is that Rio Tinto's other assets include mines that contain
numerous other minerals, offering far more diversification. In this case, that
diversification gives investors reason to check out the stock, which trades at a
P/E in line with its long-term expected growth rate of 8%. Not so with Blue Nile
(NASDAQ: NILE ). The diamond retailer is trading at a crazy multiple of 40 times
earnings on 20% earnings growth, while in the trailing 12 months it had net
income of $10 million but had negative free cash flow of $20 million. And it
has meager margins of 3.8% to boot. The real threat to Blue Nile is Internet
competition. Never mind that you can find just about any precious stone or
jewelry on eBay (NASDAQ: EBAY ) there are even teeny little upstarts like DGSE
Companies (NASDAQ: DGSE ) that have a glob of 900 different websites through
which business can be transacted, plus an increasing store presence. All of
these are reasons why the famous Zale Corporation (NYSE: ZLC ) is sitting at
$3.74 per share, off 90% from its all-time high. Zale has been losing tons of
money year after year (a $112 million loss last year, with no end in sight), and
has almost $500 million in debt, while it struggles with negative cash flow. The
company is in very real danger of bankruptcy, which should serve as a cautionary
tale for all of the other names in the sector. Diamonds may be a girls best
friend, but theyre certainly not an investor's. Lawrence Meyers owns shares of
DGSE and is short NILE.