Muddied Waters at Blue Nile

For investors who value management candor as much as quality of earnings, the silence from Blue Nile (NILE - commentary - Cramer's Take) executives over questions about their "true" free cash flow is disturbing.

I wrote last month that the online diamond and jewelry seller's impressive finances and competitive advantages made it one to watch. However, management's failure to explain its free cash flow accounting has led me to decide to sell the stock.

By using the Internet to create a "virtual" storefront, Blue Nile has been able to get bigger every year without making costly investments in diamonds, settings and other jewelry. These savings are then passed on to consumers in the form of lower prices, about 20% to 40% off those at brick-and-mortar retailers.

Budget-minded shoppers have embraced the Blue Nile approach, as evidenced by the 41% compound annual growth rate in revenue since 2002.

Equally impressive, working capital fell to negative $40.9 million as of Jan. 1 vs. negative $13.3 million at the end of 2002. When revenue goes up and working capital falls, this source of cash boosts operating cash flow and free cash flow, two metrics that savvy investors follow closely.

Blue Nile is proud of its cash-generating ability. In a February Securities and Exchange Commission filing, management states that non-GAAP free cash flow for 2005 was $30.2 million, vs. $13.2 million in GAAP earnings:

Blue Nile's management believes that non-GAAP free cash flow provides meaningful supplemental information regarding liquidity. Blue Nile believes that both management and investors benefit from referring to this non-GAAP measure in assessing the performance of Blue Nile and when planning and forecasting future periods.

While Blue Nile is technically correct about last year's cash earnings, it is not giving investors the full story.

Some $7.1 million of the $30.2 million of free cash flow is from deferred taxes. Think of this source of cash as a kind of rebate from the IRS, the result of losses from 1999 through 2001. While the accounting is proper, deferred taxes are a low-quality, nonrecurring item. On an ongoing basis, Blue Nile's 2005 free cash flow is $23.2 million.

Blue Nile's 2005 Free Cash Flow
(in $1,000s)	SEC filing	Earnings Power
Net cash provided by operating activities	$31,272	$31,272
Less: Deferred income taxes	n/a	-7,062
Less: Purchase of fixed assets, including internal-use software and website development
Non-GAAP free cash flow	-1,072	-1,072
	$30,200	$23,138
Source: EarningsPower.com, SEC filings

Adjusted Free Cash Flow
	2004	2005
Non-GAAP free cash flow (Blue Nile)	$27,918	$30,200
Percentage increase YOY		8.20%
Less deferred taxes	-5,388	-7,072
Adjusted non-GAAP free cash flow	22,530	$23,138
Percentage increase YOY		2.70%
Source: EarningsPower.com, SEC filings

Given that 23% of last year's free cash flow was courtesy of the IRS, you would think management would provide a cautionary statement. Unfortunately, its 8-K is mum on the subject. As a result, anyone who values Blue Nile on the basis of the $30.2 million figure will think the company is cheaper than it really is. In a conference call after the 8-K was filed, Mark Vadon, Blue Nile's founder and CEO, reiterated the $30.2 million free cash flow figure without elaboration or context.

A second problem is that the 8-K overstates year-over-year growth in free cash flow. While Blue Nile Chief Financial Officer Diane Irvine says cash earnings rose 8.2% in 2005, a more honest number is 2.7%.

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At the time of publication, Heiserman was long Blue Nile, although holdings can change at any time.

Hewitt Heiserman conceived the Earnings Power Chart and the Earnings Power Staircase. A graduate of Kenyon College with distinction in history, Heiserman is a member of the Boston Security Analyst Society and the CFA Institute. He also authored It's Earnings That Count. For additional information, please visit www.earningspower.com. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Heiserman appreciates your feedback; click here to send him an email.

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