Readers familiar with my value bent and fondness for dividends are probably going to scream "hypocrite!" on this one. But I'm taking the bull side of the argument for Motley Fool Rule Breakers and Motley Fool Hidden Gems newsletter selection Blue Nile (NASDAQ:NILE), a company that's been public for less than two years, pays no dividend, and has a P/E over 50 (gulp). I can hear the question now: "How do you fit that into your portfolio, Mr. Dividend Doofus?"

Very carefully.

I say that with a bit of a smirk, but I am serious. As the leading online seller of diamonds and jewelry, Blue Nile has a good chance to be something very special. It also has a chance to blow up in your face. I wouldn't feel comfortable making it an overweight position in a portfolio, and I haven't, but I do think it's a worthwhile speculation in a small portion of a portfolio.

A unique business
Anyone can sell diamonds and jewelry online, and many companies do. What makes Blue Nile unique is the transparency the company has brought to selling diamonds, in an industry notorious for keeping consumers as much in the dark as possible. Before Blue Nile, if you wanted to get what you paid for when buying a diamond, you usually had to know someone in the business, pay a premium for quality at a trusted establishment like Tiffany & Co. (NYSE:TIF), or simply have good luck. Most buyers weren't lucky.

With Blue Nile, you can pick out the exact diamond you want, and mate it with a wide variety of settings. By itself, that's not so special, because there are a few other sites that mimic this model. Blue Nile has separated itself from the pack by guaranteeing what it sells, not skimping on the presentation aspect of receiving a fine piece of jewelry, and offering a wider selection of items, particularly diamonds. The last item has been accomplished in a fairly unique manner, which warrants further discussion in a bit.

Not as expensive as it appears
First, let's deconstruct that dreaded P/E of 52, because GAAP net income really doesn't do the cash dynamics of this business justice. In the last 12 months, Blue Nile has delivered diluted earnings per share of $0.62, which when divided by the company's stock price of $32.80 yields the P/E. Over the same period, Blue Nile has delivered free cash flow (FCF) of $1.06 per share. Divide that by the same share price, and you get a P/FCF of 31. That's still not cheap, but Blue Nile's free cash flow has increased in each of the last three fiscal years, and the average free cash flow per share over that period is $1.07. I can comfortably say we're at the high end of a reasonable valuation, assuming that Blue Nile hits analysts' estimates of 30% growth.

The only problem with the above argument is that analyst estimates are often overly optimistic. In fact, I consider them so optimistic that I rarely use them for anything other than a best-case scenario. The first fallback for a valuation model here is Blue Nile's balance sheet. Blue Nile is sitting on $81 million in cash (14% of its market cap), has no interest-bearing debt, and has only $8.8 million of inventory on its books.

I've touched on the variety that Blue Nile offers customers, and its relatively low inventory balance of $8.8 million. The two appear to be at odds, until you consider that a large portion of the diamonds that Blue Nile sells aren't held in its inventory. They're held in its vendor's inventory, and when a customer selects a particular diamond in an order, Blue Nile buys it from the vendor. This means Blue Nile sells most of its diamonds long before it has to pay for them, which leads to a negative cash conversion cycle, the second justification for the full valuation. If this inventory model sounds familiar, it's probably because it's similar to those employed by Motley Fool Stock Advisor picks Dell (NASDAQ:DELL), (NASDAQ:AMZN), and Costco (NASDAQ:COST).

Foolish final thoughts
Blue Nile brings a well-respected business, a reasonable valuation, a sound balance sheet, oodles of free cash flow, and a negative cash conversion cycle to the table. The only reason for caution, and it's an important one, is price. The company is reasonably valued here, meaning that future returns will depend upon continued growth or an expansion in the multiples of earnings that investors are willing to pay. The latter is not likely, but the former isn't unreasonable.

Wait! You're not done. This is just a quarter of the Duel! Don't miss Chuck Saletta's bearish beginning, Chuck's rebuttal, or Nate's final word. When you're done, you're still not done. You can vote and let us know who you think won this Duel.

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Nathan Parmelee owns shares in Blue Nile and Costco. He has no financial stake in any of the other companies mentioned. The Motley Fool has an ironclad disclosure policy.