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No. of Recommendations: 10
In response to a question from Jeff Fisher of Complete Growth Investor, here are my comments on Blue Nile:

Jeff, Other CGIers:

I owned Blue Nile (NILE) a few years back but then sold due to: 1) the rich valuation after assuming a normalized tax rate, and 2) management's decision to include the tax loss benefit in the free cash flow number they were telling investors, even though they knew this benefit was non-recurring. I called and/or e-mailed CEO Mark Vadon and chief financial officer Diane Irving 7-8 times over a four-week period concerning this matter, but they didn’t respond. So my feeling for the Seattle-based jewelry e-tailer was similar to the way tming3 felt after trying to interview China Fire (CFSG) management, and which he explained on the CFSG board several months ago.

Anyway, here are a few thoughts:

Nile has filed its 2007 10-K. Operating cash flow is $41 million, which includes $6 million of stock-based compensation, and another $7 million of option tax benefits. Given the non-operating nature of these items, I'm treating them as costs. Under this more conservative scenario, adjusted operating cash is $28 million. Meanwhile, capex was $5 million, so free cash flow is $23 million. GAAP net income was $17 million for this same period.

The reason Nile makes more money on a cash basis than on GAAP is its capital-light balance sheet. Current liabilities included $86 million of payables for Dec. 2007, vs. $67 million for the prior year. This $19 million increase is a source of cash. The bigger the year-over-year increase in payables, the bigger the source of cash. (With current assets the situation is reversed; the bigger the YOY increase in receivables, the bigger the use of cash.) Key point: If sales slow, payables growth will also slow. This means a diminished benefit to operating cash flow.

Nile's biggest asset is the $123 million of cash and equivalents. Are any in auction-rate securities? The footnotes are vague. From pg. 41: "The Company considers all highly liquid investments with maturity of three months or less when purchased to be cash equivalents." I'd want more details on what these cash and equivalents consist of before buying Nile's stock.

Speaking of cash, Nile earned $4 million pre-tax from its cash and equivalents last year. Since this is a non-operating item, let's subtract it from the $23 million estimate above. Free cash flow is now $20 million. Adjusted GAAP net income also declines by $3 million, to $14 million. If you reduce Nile's earnings, then also apply the $123 million of cash to reduce its market value. The cheaper a firm's market value, the more assets and earnings you get for your investment.

In the last 3 years Nile spent $82 million on share buybacks, reducing share count by 2 million shares to 15.8 million shares. These 2 million shares were awarded to employees, as far as I can tell. I do not like that Nile awards options so freely. The company would have a lot more cash, or a lot fewer shares, if they were stingier. Follow Mr. Buffett’s example and pay bigger salaries instead.

Valuation? Here are two calculations I run at the beginning of my research. My goal here is avoid wasting time on companies that are well outside of my intrinsic value parameters. They are: 1) Year 3 CAGR, and 2) PIV-ER. If you add these time savers to your initial due diligence, you'll cover more companies faster.

Year 3 CAGR. If Nile enjoys the same TTM FCF multiple in year three as now (27x, after deducting excess cash), then you’ll make 8% a year, provided free cash flow grows 21% a year as analysts expect. To earn 25% a year for the next three years--which is the kind of return you want to aim for with a small-cap like Nile--buy below $30.

What if Nile's cash-adjusted FCF contracts over the next three years to, say, 18x? Then your 3-year CAGR on investment is -5%. The buy below price is $23.

PIV-ER. My three-year CAGR scenario assumes Nile grows at 21% a year, as analysts forecast. But analysts are often optimistically wrong, as David Dreman’s research shows. So, I also use a three-scenario mean regression model. In Nile’s case, High growth is 23% a year for the next five years, just as analysts expect. Medium growth is 75% of the High, or 17.25%. And Low growth is 50% of the High, or 11.5%. Then in year six each of the three growth scenarios get chopped in half, to take into account the possibility of increased competition, management screw-ups, changing consumer taste, the economy tanks, Mt. Rainier erupts, etc. Beginning in year 11 terminal growth is 3% across the board. By this admittedly formulaic approach, Nile’s intrinsic value is $39, its price-intrinsic value (PIV) is 109%, and the expected return is -8%. (Expected return is: ($39-$42)/$42). None of these numbers are attractive to me. For Nile to reach my target 65% PIV, the stock must fall to $25. Share dilution is estimated at 1% a year for years 1-5.

Note the target $25 stock price from PIV-ER is close to the $23 target from my Year 3 CAGR model. So, my buy-around price is in the low-$20s, provided that I like the rest of the business. Will Nile ever get this cheap? Anything is possible, especially since this was a $100 stock not long ago.

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