Last weekend, after feasting over some slightly blackened filet mignons and slushy mash potatoes, the remaining partygoers that hadn't run scared from my near-disaster barbecue began discussing diamonds. The dialogue was sparked because my roommate recently got engaged and many of the fervent, single women in attendance wanted to hear how he came to choose the engagement ring.

The discussion got my full attention, considering the Rule Maker Portfolio has devoted three columns to high-end jeweler Tiffany (NSYE: TIF). Todd Lebor began by discussing the threat of competition from De Beers, which controls 70% of the market for rough diamonds. Then, I followed up with two columns about Tiffany's lackluster working capital management and cash flow generation.

The three columns haven't painted a flattering picture of Tiffany, and raised serious Rule Maker limitations. There are probably more positives about the company than negatives, however. A long operating history, dominant brand, and growing moat around the company's business are what drove us to consider Tiffany. Nevertheless, we haven't spent much time discussing these strengths. 

We want to invest in proven companies. Coca-Cola (NYSE: KO) has been around for more than a century and has withstood great economic change. Likewise, Tiffany has been in business for more than 160 years, surviving and succeeding through difficult economic and spending conditions. Thus, by operating through multiple business cycles, we have a certain amount of faith and insight in Tiffany's business.

Tiffany has been able to succeed because of its dominant brand. Its signature blue box has become synonymous with the jewelry industry, representing its reputation for fine craftsmanship and superior merchandise. There are also a certain amount of bragging rights associated with Tiffany merchandise, which has allowed the company to charge higher prices for products that at the end of the day aren't much different than what family-owned jewelers offer down the street.

Lastly, we're attracted to Tiffany because it has a moat around its business. We've seen this work before: Microsoft's (Nasdaq: MSFT) dominance in the operating system market, for example, created a moat that kept its competition at bay. Likewise, Tiffany's brand will make it very difficult for a company to take its leading position. The only chance the competition has is for Tiffany to destroy its own brand, but given the premium it places on quality that's highly unlikely.

These strengths make Tiffany a strong investment prospect, but they don't necessarily make it a Rule Maker. As we said before, the inventory requirements of the jewelry industry make it impossible for Tiffany to have a Foolish Flow Ratio below 1.25. But because jewelry inventory doesn't face the same risks of obsolescence as technology products, we were initially inclined to overlook its high Flow Ratio.

We're less comfortable with Tiffany's cash flow, a result of poor working capital management. Increasing inventories have decreased cash and the company's Cash King Margin remains fixed below 10%. The inventory problems appear short-term, however. We understand part of Tiffany's success is its ability to keep lots of product on hand, but that doesn't explain why inventory continues to increase faster than sales, and we'd want to see improvement in this area before investing any Rule Maker money.

Truthfully, it's hard for retail companies to produce enough free cash flow to meet our Cash King Margin criteria of 10%. Our last Rule Maker retail endeavor, Gap (NYSE: GPS), only made the cut once on an annual basis in the last 10 years. The capital expenditure requirements are very high because growth is often driven through new store openings. That's what makes it hard for solid retail companies like McDonald's (NSYE: MCD) and Starbucks (NYSE: SBUX) to have Cash King Margins above 10%.

Let's revisit Tiffany's numbers for the last three years:

($ millions)            2000     1999     1998
Cash Flow From Ops.   $109.2    230.4     80.2
Net Capital Exp.      $108.4    171.2     62.8
Free Cash Flow           0.8     59.2     17.4
Net Income            $190.6    145.7     90.1
Cash King               0.5%       4%       2%

Even if Tiffany can get its inventory under control, it's uncertain whether it could produce enough free cash flow to become a Rule Maker. It continues to spend on new-store openings, renovations, expansions of stores, and renovation of manufacturing facilities. In 2000, Tiffany also incurred significant costs related to construction of a jewelry manufacturing facility in Rhode Island. In January 2001, it began renovating its New York store at a cost of $71 million. This flagship store made more than 14% of the company's top line last year.

We're also unsure about the company's price. Tiffany closed yesterday at $34.84 per share, leaving it with a market cap of $5.1 billion and trading at 26 times 2001 earnings. Given that it's expected to grow earnings 18% annually over the next five years, that valuation doesn't look unreasonable. But as Rule Maker investors, we want to know if its market cap can increase two times over the next five years.

Looking at Tiffany's P/E history, you can see that its current P/E is a little higher than the historical five-year average:

TIF       '00    '99    '98    '97    '96 
P/E        30     38     23     19     23

We'd prefer to value the stock based on historical price-to-free-cash-flow ratios, but since it hasn't produced a significant amount of cash flow we're stuck with earnings (calculated at the end of each fiscal year). If the company improves its working capital management and return on invested capital, we'd expect the P/E to increase.

Two times Tiffany's current market cap puts it at $10.2 billion in five years. We've assumed 3% dilution because of stock options, translating into a market cap of $10.5 billion. We've also assumed an expected net profit margin of 14%. Currently, its net profit margin is 12%, but it continues to produce more products internally, a less expensive practice that should improve its margins.

With these assumptions, let's take a look at what level of sales growth will be necessary to achieve 2x/5y at various future P/E multiples:

Projected P/E              30      25       20
Year 5 Earnings ($B)     0.35    0.42     0.53
Year 5 Revenue ($B)      2.51    3.01     3.76 
Growth Rate for 2x/5y    8.6%   12.6%    17.8%

In order to appreciate two times in five years, Tiffany would have to post $2.51 billion in revenue in year five, growing its top line 9% annually. That seems achievable to us, as the company continues to increase its market share, which currently stands at 4%, of the $44 billion jewelry market. Then again, we've assumed a P/E of 30, which is probably too high. If we lowered the P/E to 20, it would need to grow its top line 18%, which appears unlikely. Either way, at the current price, we're not so sure the rewards outweigh the risks.

It's become increasingly clear Tiffany isn't a Rule Maker, but that surely doesn't imply the company won't make a good investment. It simply means the company falls short of too many of the important characteristics we require of Rule Makers. Therefore, we've decided to move on. We'll continue watching Tiffany's working capital management, cash flow generation, and price. If there's improvement, we'll revisit the company. We love its brand, history of execution, and growing moat.

In other news, Tiffany warned after the market's close yesterday, citing difficult economic conditions. The company now expects earnings of $0.23 to $0.25 per share. That's at the low-end of Wall Street's expectation of $0.25 per share.

Mike Trigg should not be held responsible. His holdings can be viewed in his personal profile. The Motley Fool is investors writing for investors.