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Overstock's Costs Pile Up on Weak Earnings

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Help yourself with the Fool's FREE and easy new watchlist service today. (NASDAQ: OSTK  ) may appeal to techno-dweebs now that it is the first major online retailer that accepts controversial cryptocurrency Bitcoin, but the Street wasn't impressed with the company's boring government-sanctioned earnings. It's not that the company performed poorly -- it increased top-line sales by double digits -- but a few things weighed heavily on investors' minds. For one, costs kept the adjusted net income from growing materially. Also, investors and analysts wanted a better holiday result. The company competes effectively in its niche, though it is nonetheless in the shadow of the retailing world's ultimate disruptor. Is Overstock a buy after last week's sell-off?

Reasonably valued, for a reason
Compared to, Overstock appears to be a breath of fresh air. The company has an extremely reasonable forward-earnings ratio of roughly 21 times, and generates decent free cash flow considering its sub-$500-million market cap. Of course, the company's competitive scope is merely an iota of its infinitely larger peer and will forever linger in its shadow.

Does that mean that is not worthy of investment? Not inherently.

Still, just like the brick-and-mortar retailers this holiday season, Overstock had a very underwhelming end to 2013. Headline numbers show an eight-fold increase in net income, though that is entirely due to a one-time tax benefit. If you look at operating income, the company actually posted a $6.4 million decrease over 2012's $7.9 million.

For the full year, top-line sales grew 17%, and in the quarter were up 16% to $397.6 million. Unfortunately, these attractive gains were substantially mitigated due to a sharp rise in sales & marketing, along with general and administrative costs.

Darn you, Google (and laws)!
changed its algorithm... again. Overstock was apparently taken by surprise when this occurred sometime in the third quarter of 2013, and subsequently lost its place at the top of search results. The company therefore had to boost its sponsored listing spending while it adjusted its SEO practices to recover. As a percentage of revenue, sales and marketing went from 6% in 2012's fourth quarter to just under 8% in this year's.

Sales and admin costs rose 19% on the year and jumped 46% in the quarter. Much of the latter's boost came in the form of legal fees, as faced multiple suits due to misleading price comparisons. The company is looking at $6.4 million in penalties.

All in all, the lack of profit growth drove the market to sell off roughly 7% of Overstock's market value. In the past month, the company has lost roughly one-third of its value.

That last bit raises the question: Is Overstock a buy now that it's taken a more than 30% haircut? 

More info needed
With such a sharp rise in marketing expense -- a necessity in today's promotionally obsessed retail environment -- there needs to be some evidence of a correlated sales increase. Instead, we've seen the opposite. The company is well capitalized and certainly has its fans, but can it continue gaining new customers in the face of an ever-broadening e-commerce behemoth? 

Overstock's biggest battle isn't in a courtroom arguing over the nuance of price comparisons, nor is it its "me first" attitude toward Bitcoin. Overstock needs to pour money into effectively showing its customers (and prospective ones) why they need it in the first place. At 21 times earnings, the company may look like an attractive e-commerce play, but right now there just isn't enough evidence that its sales and marketing push is working. 

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Michael Lewis

Michael is a value-oriented investment analyst with a specific interest in retail and media businesses. Before coming to the Fool, Michael worked with private investment funds focusing on deep value and special situations. Currently living in the media capital of the world--Los Angeles, California.

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8/28/2015 4:00 PM
OSTK $20.14 Down -0.28 -1.37% CAPS Rating: *