Step 1: Earnings Quality

The purpose of the free cash flow, or defensive, income statement is to reveal whether the company is able to self-fund its operations based on internally generated free cash flow. A company is able to self-fund when it produces more cash from ongoing operations than it consumes. The defensive income statement is unique in that investment in fixed (No. 1) and working (No. 2) capital are expenses, just like raw materials, salaries, and shipping costs.

For the year ending Jan. 1, 2006, Blue Nile earned $1.04 a share of defensive profits, vs. $0.71 a share of the GAAP variety.

Our other alternate ledger, the economic value-added, or enterprising income statement, shows whether a company is creating value. A company creates value when it earns a return on capital that is greater than its cost. The enterprising version is unique because intangible growth-producing initiatives like advertising (No. 3) are capitalized as assets (which matches sales with expenses), and the opportunity cost of stockholders' equity (No. 4) is deducted, just as if it was debt. Blue Nile's enterprising profits were 76 cents a share in 2005. (Blue Nile had tax losses carry-forwards from prior years, which distorts earnings for all three income statements. To create comparability, all profit figures in this report are presented on a "fully taxed" basis.)

Blue Nile's Earnings Power The three columns tell a powerful tale
Blue Nile (NILE) (thousands except per-share)Fiscal year ending Jan. 1, 2006	Defensive	GAAP	Enterprising
Revenue	$203,169	$203,169	$203,169
Cost of goods sold	158,025	158,025	158,025
SG&A	18,968	18,968	18,968
Investment fixed capital (No. 1)	(653)	na	na
Investment working capital (No. 2)	(9,166)	na	na
Intangibles (No. 3)	8,127	8,127	6,376
Other	203	(2,504)	78
Interest expense (No. 4)	0	0	(2,517)
Taxes	8,381	7,400	8,161
Expenses	183,884	190,016	189,090
Profit	$19,285	$13,153	$14,079
Shares outstanding	18,597	18,597	18,597
Per-share	$1.04	$0.71	$0.76
Source: Reuters Knowledge, Earnings Power.com

Now we compare these three EPS figures on a quality of profits chart, as shown below. If the company is profitable on a GAAP basis, is it also profitable on a defensive and enterprising basis? In Blue Nile's case, the answer is yes.

I also want to see how tight the fit is between GAAP, defensive, and enterprising earnings. The tighter the fit -- meaning the closer the tops of the bars for defensive and enterprising profits to the GAAP bar -- the better. For the last four years, Blue Nile's defensive and enterprising profits have exceeded its GAAP profits, which is both impressive and rare.

Finally, what is the trend over the last several years? GAAP profits have risen every year since 2002, and enterprising profits have marched in lockstep. Defensive profits, on the other hand, declined in year-over-year in 2005 because its negative investment in fixed capital as a percentage of sales fell by 210 basis points. I am not worried by this one-year trend, but it is a data point to watch.

Blue Nile's Quality of Profits These are strong, but monitor defensive earnings

Now plot the intersection of defensive and enterprising profits on the Earnings Power Chart. The Earnings Power Chart is the graphical presentation of corporate profitability from both a pessimistic and optimistic view. Strength in both is required for a company to possess authentic earnings power.

Blue Nile has sat in the upper-right box every year for the last four years, as shown below. This means the company is profitable in the broadest possible sense of the word.

Blue Nile Runs Strong The company is profitable in the broadest sense of the word