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No. of Recommendations: 10

Can you elaborate on the misleading cash flow?
Blue Nile is my current poster child for crazy valuation.Selling at a huge premium to other jewelers with a PE of around 115 and EV/EBITDA of 50 I can't understand the fascination. Growth is decent at 20% EPS growth yoy last Q2 but is it worth the current price? Sounds like you sold too soon :(

Not Hewitt, but have written on the subject once-or-twice...

What I think has been really neat to watch about NILE is not the woes of those who might have "sold too soon" (a strange statement, in my mind, since, if you realize a company you own is, after-the-fact, engaging in misleading behavior misaligned with your own investment interests, it cannot - I believe by definition - be termed "selling too soon" without benefit of hindsight...and my crystal ball doesn't work very well).

Rather it is the ever greater assumptions that are getting trotted out to justify the investment case TODAY. The last analyst (that I saw) that jumped on the upgrade bandwagon (Citigroup) set a price target of $88, or 52 times his 2009 earnings estimates. He did so when the stock was trading around $79, meaning he was calling 'Buy' on a stock that he expected an annual return on of less than the 2-yr T-Bond (then yielding 4.86%).

Of course, the stock promptly ran to $98 in the weeks following earnings.

All the while, insiders have been cashing out:

* CEO Mark Vadon reduced his stake from 1.406MM shares to 1.011MM shares from 1-Jan-07 to 14-May-07 (a 28.1% reduction).

* CFO Diane Irvine reduced her stake from 115.8K shares to 40.4K shares from 1-Jan-07 to 31-May-07 (a 65.1% reduction). Moreover, if you back up two months to 8-Nov-06, her stake has sold off from 186.9K shares, down to 40.4K (a 78.3% drop).

* Sr VP Gaston Dwight dropped his stake from 15.5K to 1.3K in 2007-to-date.

* Sr VP Susan Bell has liquidated her entire position in 2007 (12K shares) which she'd largely maintained for the past few years.

Meanwhile, all of the $0.25 strike options that everyone and their dog got prior to NILE's IPO continue to exercised into reality, replacing the much-touted share repurchases. If you subscribe to the concept of 'Unfettered Free cash Flow' (described in the above links as punishing so-called free cash flow for the impact of buybacks completed ostensibly solely for the purpose of offsetting option dilution), then NILE trades today at 58 times unfettered Free Cash Flow; and I'm even generous enough to add back the non-cash stock-comp expense before I do the unfettered calcs.

And should we highlight that the company repurchased exactly zero shares in Q2-07 when the share price fluctuated between 40.53 and $62.30 (it's $87.50 as I type this). Why might the repurchase program have been halted? Could it be that management, share compensation gorge-monkeys though they may be, actually understand the value of their own shares?

From the Q2 conference call:

"I guess what we'd like for everyone to understand about the share repurchase program is we'll
always be very thoughtful in how we execute that program. Certainly looking at our balance sheet
opportunities for investment, you know we need to be very prudent from a capital allocation standpoint
and make the right decisions in the buyback program. We want to always do what's right for our
shareholders. And I think we've done that. In the past 2.5 years we have retired 15% of our
outstanding shares. Today we have more cash on our balance sheet than we did even after becoming
a public company. So over time that will continue to be a very strategic program for us."

Interesting stance on capital allocation, I think, for a company so famously capital light (they expect to spend $5MM in CapEx for all of 2007 - a number that contains several significant growth initiatives, versus 2006's CapEx of $1.9MM, and the widely-cited negative working capital structure). Of course, there are those out there who argue that share buybacks are always a worthy use of shareholder capital; a wrong-headed, but somewhat common stance, IMHO.

And yes, while they have repurchased 15% (actually 15.2%) of outstanding shares in the past 2.5 years, what they fail to mention is that, over that same period, about a third of those shares have already been returned to the market via option exercises, there are roughly 1.95MM options still outstanding (including roughly 400K at a strike of $0.25 - no, not a typo) - all well ITM, and management has flat-out stated they intend to continue issuing 3% of the company's equity annually in the form of options.

But, you know, the company is growing revenues at 25% annually (past 3 years), so all is good, right?

Sorry for all the NILE BILE (heh), but I think it's important to recall that Hewitt's IETC process is actually a tri-phase approach:

1) Assessing Earnings Power/Quality
2) Assessing Competitive Advantage
3) Valuation

When I look at NILE (a company I actually really like - which is probably why all this bugs me to no end), I think it's a company that does reasonably well by the QoE and EPC charts, as well as on competitive advantage, but is a woeful, woeful, failure on the valuation front.


(P.S. Nice to see this board get active again - Hewitt, sorry I probably won't see you in Vegas!)
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