Fire Sale on Overstock?

Despite a great business model, Overstock has yet to turn a 12-month profit. It's a new business and investors should own it only as an informed speculation. In other words, it's not for everyone, and expect a wild ride.

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By Tom Jacobs (TMF Tom9)
July 31, 2003

An after hours slide that began last night when Overstock.com (Nasdaq: OSTK) reported a Q2 loss continued into regular trading today. The stock topped the list of Nasdaq losers, plummeting as much as 20% intraday and looks likely to close below $11.00, well off its June 20, 2002 IPO close of $13.22.

The everything-you-want-cheap online liquidator narrowed last year's $0.20 a share loss to $0.07, on revenue that doubled to $28.8 million. But because the Street was expecting $30 million in revenues, sellers attacked the stock.

Let's see if anything in the report suggests that the new business is not moving ahead. 

Slight improvements
Gross margins declined from last year's 17.7% to 16.7%, but operating expenses showed improvement. Overstock divides SG&A into two groups: selling and marketing expenses in one, general and administrative in the other. The former declined slightly from 9.1% of revenues [Ed.: Originally published as 14.4% and corrected after publication to 9.1%] to 8.9%, while the latter dropped from 15.3% to 11.7%.

According to numbers teased out from the conference call, free cash flow was a negative $10.3 million, consisting of negative $9.0 million in net cash from operations and $1.3 million in new capital expenditures. That burn doesn't threaten the company's $31.6 million in cash and equivalents with only one quarter to go before Q4, but then it gets sticky. So far Overstock's performance is typical of retail, so Q4 will have to be a barnburner to cushion the following three quarters of cash burn.

Conference call good and bad
CEO and Chairman Patrick Byrne and President and CFO Jason Lindsey chaired the earnings call this morning. Both managers tend to be low key and hype free, a nice change from most who behave as if quarterly conference calls were either dreaded tasks or venues to hype the stock. Their honesty and lack of PR hype can infuriate shareholders and analysts that confuse spin with business acumen.

As noted in Overstock's Buffett Style (a good place to start your research), Byrne spoke frankly on the Q1 call about management's mistakes. In today's call Lindsay opened with the three main Q1 challenges and how management fared in Q2. First, though gross margins declined slightly year over year, they inched up sequentially. Second, "too high" general and administrative expenses fell $1.2 million sequentially. And third, "inefficient" sales and marketing improved, with related expenses dropping $1.2 million with just a 1% decline in sequential sales and 100% jump year over year.

Byrne's Top-10
Byrne addressed ten critical issues -- some good and some not so. Overstock added 283,000 new customers during the quarter. The company's dealing with the welcome challenge of tracking new traffic from the July 1 launch of its portal deal with Microsoft's (Nasdaq: MSFT) MSN, but also the problem of more so-called spiders (web crawlers) trolling Overstock for pricing information.

Regarding a pact with Palm (Nasdaq: PALM) to liquidate PDAs, Byrne shared the interesting fact that, on average, a manufacturer will ultimately have to liquidate 5% of its production -- and two to three times that in the fashion industry. That should mean a steady supply of Palms for bargain-hungry shoppers.    

Cost per customer acquisition dropped from $14.06 in Q1 to $8.68, and variable cost per package dropped to $1.82 -- "phenomenal in this business," according to Byrne. The company is now processing all customer returns to ensure quality across its many affiliates.

Overstock also plans no change to its $2.95 flat shipping charge -- whether for a watch or flat screen TV (wow!). Byrne referred to the Amazon (Nasdaq: AMZN) policy as "free shipping with asterisks" while he and Lindsay said they remain open to occasional discounts such as $1.00 shipping.

One interesting stat: The percentage of female customers remained steady at just over 66%. In my last job, it was a regular event for women I worked with to storm a downtown liquidator to see what was in stock. No wonder women flock to Overstock too.

On the negative side, Byrne confessed that his dreams of $10 million to $20 million in monthly revenues from a relationship with Safeway (NYSE: SWY) won't come to pass. Also, the company lost $750,000 through a deal with a refurbisher that it terminated June 30.  

Informed speculation
Byrne said he wants to maintain triple-digit year-over-year revenue gains, referring repeatedly to four unnamed projects. Those plans are crucial to turning an unprofitable company operating in an intensely competitive environment into a long-term sustainable business that can deliver profits and free cash flow. Meanwhile, unless the triple digit revenue growth brings in more cash, the company may need to raise some next year, when the capital markets may or may not be sympathetic.   

The online model is great for the liquidation business, and nothing in the quarter's news implies a material change in Overstock's prospects. But they are just that -- prospects. That's why I characterize my ownership of the stock clearly as an informed speculation.

In making your own decision, enjoy the investing process. First, know how much risk you want to take on -- if any. Learn about management yourself by listening to the latest informative call, read the quarterly and annual reports, and track the progress of new projects. Along the way, make it all easier by joining the spirited discussion on the Overstock discussion board.   

If you decide to stock up on Overstock, keep the risk to your comfort level. And prepare for volatility.

Have a most Foolish weekend! 

Want financial roadside assistance? Enjoy your free TMF Money Advisor trial today!

Writer and senior analyst Tom Jacobs (TMF Tom9) wants to liquidate his collection of clutter. Any takers? He welcomes your comments at TomJ@Fool.com. Tom owns shares of Overstock and Microsoft, as well as others you can find in his profile. The Motley Fool is investors writing for investors.