FOOL ON THE HILL
Overlook Overstock.com

Internet e-commerce has been a rare bright spot for investors over the last year. This certainly played a part in Overstock.com's timing decision for its IPO. Don't let it play a part in your decision to invest.

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By Tom Jacobs (TMF Tom9)
May 30, 2002

[This article was updated on 5/31/02 to reflect VA Linux Systems' 6/00 purchase of Andover.net.]

I've always loved the line, "It strains credulity." It's a polite way for someone to say, "I can't $%$^&*!!!@#@! believe it!!" and be invited back to the NewsHour or dinner.

Well, folks, Overstock.com's (Nasdaq: OSTK) $39 million IPO strains my credulity. And yet, it is what it is: an online liquidator ("Name brands at clearance prices") with no discernible competitive advantage such as consumer brand, and a $200 million-plus market cap with $40 million in 2001 sales. Take a wide berth on this one.

Internet e-commerce has been a rare bright spot in the market over the last year, leading to an increase in IPOs this year from 2001's one, down from 98 in 2000. Overstock.com, DVD renter NetFlix (Nasdaq: NFLX), and payment facilitator PayPal (Nasdaq: PYPL) have sold shares to the public since January, and three more are on the way. This is a Foolish reminder, that IPOs are financing events for companies and almost never opportunities at the time for investors -- though the companies may be good investments later once we have time to see them operate in public view.

W.R. Hambrecht & Co., Overstock.com's investment bank, sold the 3 million shares in an open auction, which they explain in a handy slide show. In what is known as a "Dutch auction," the company specifies how many shares are available and provides a price range. The bidders state the number of shares they want and the price they are willing to pay, which can be any price.

The auctioneer takes in all the information and the company determines the offering price by looking at the bids and figuring at what price all the shares will sell, or "clear." It fixes the offering price, and then bidders at or above that price receive shares. The company may decide to set the price at the level at which all clear, or set it lower and award the same amount of shares to bidders based on their bid share amount. Overstock.com set a range of $12-$16, reviewed the bids, and chose $13.

The company has raised some money for clients using this method, but don't be confused by the list on their OpenIPO page -- that's a total list of their investment banking business, including traditional IPOs and follow-on share offerings. You have to click for a list of actual OpenIPOs, which tells the story more clearly:

Company     Ticker Price Date  Raised  Currently 
Overstock.com OSTK $13    5/02 $39 mil. -- 
Briazz, Inc.  BRZZ $ 8    5/01 $16     $1.38
Peet's Coffee PEET $ 8    1/01 $26     $15.85
Nogatech, Inc.     $12    5/00 $12 bought @ $10.49
Andover.net   ANDN $18   12/99 $83 bought @ $45.13*
Salon.com SALNC $10.50 6/99 $27 $0.12 Ravenswood $10.50 4/99 $12 bought @ $29.50
*By VA Linux Systems, now VA Software (Nasdaq: LNUX),
which closed 5/30/02 at $0.92 a share.

Not a huge success judged by number, and none since 2001.

I have to wonder why a company with real prospects would choose an auction because, even in today's dismal capital market, institutions would be interested in its shares. The company's slide show provides a hint that OpenIPO's intended audience is probably (gullible? impressionable?) individual investors, whom it depicts jumping up and down with success as if this were the eBay of IPOs. Don't bite. Sure, the stars of tomorrow are debuting today, but you can usually afford to wait at least a few quarters to examine a firm's progress as a public company and evaluate its management effectiveness.

What are Overstock.com's prospects? Checking its first March 2002 registration statement, S-1, we see no profits, but increasing sales.

                    1999   2000    2001 
Total Revenues      1,835 25,523  40,003  
% increase           --    --      57.0%
Costs of Goods Sold 2,029 27,812  34,640
Gross Margin         --    --      13.5%

It's too short a story for me right now. I like to apply our Rule Breaker strategy to any potential investments in developing unprofitable companies, and Overstock.com fails here. It's not a top dog or first mover in Internet e-commerce discounting, and I can find no sustainable competitive advantage (a "moat") for the business.

But if over the next several quarters I see accelerating sales, costs that did not increase relatively, and stable or increasing gross margins, it might be that Overstock.com has some special sauce it's serving up against its  universe of competitors, from offline retailers like Ross Stores (Nasdaq: ROSS) to online competition from Amazon (Nasdaq: AMZN) and eBay (Nasdaq: EBAY) and "specialty" discounters like Best Buy (NYSE: BBY). The company would clearly be worth another look. (By the way, speaking of Amazon, the IPO was its opportunity to cash out of its 7% of the company. Not much cash, but better than Jeff Bezos has realized from a host of other Internet retailing investments.)

I recently detailed some successful Internet e-commerce companies, whose expanding profits -- or at least prospects -- have rewarded their shareholders. Unless I'm missing something, Overstock.com won't be one.

Are you hot or cold for IPOs? Jump in on our lively IPO discussion board! And please take this poll:

A. Are you nuts? I put no money in developing, unprofitable companies.
B. I allocate less than 20% of my portfolio to such companies.
C. I allocate 20%-50% of my portfolio to such companies.
D. More than 50%. And I'm sticking to it!

Tom Jacobs (TMF Tom9) is taking bids for his IPO. Just send checks. At press time, he owned no shares in companies mentioned in this story. To see his stock holdings, view his profile, and check out The Motley Fool's disclosure policy.