My Take on the AH Reaction

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By CorporalCarrot
January 28, 2005

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I notice from this board and also the Yahoo! Board almost a sense of disbelief or bewilderment at the after hours reaction to Overstocks most recently announced results. I mean, they blew away estimates didn't they? It's their first profitable quarter in two years isn't it? Surely that means the stock should be heading upwards?

Well, it isn't that simple. Because as I have long maintained with eBay, for example, performance is irrelevant unless it is put in the context of valuation. And where stocks are priced to perfection, the amount of performance required in order to justify that valuation is stratospheric.

And since I entered a bearish straddle just before the close last night, let me share with you my thoughts on the company and how the results bore out my fundamental short bias on the company.

Firstly, lets look at the valuation in basic terms. Before earnings last night the company had a market cap of approximately $1.3bn. This is pretty lofty valuation for a company estimated to earn approximately $7m next year, representing a p/e of 185. I don't care what anyone says about growth etc. There is a huge risk premium in this stock.

Secondly lets look at the results. Here are the highlights from the company's press release.

Summary of fourth quarter results:
* Total revenue: $221.3 million, up 80% versus prior year
* Gross bookings (excluding auctions): $237.0 million, up 82% versus prior year
* B2C gross bookings: $233.4 million, up 95% versus prior year
* Gross margins: 15.2% versus 13.3% in Q3 and 9.6% in Q4 2003
* Net income: $2.5 million or $0.12 diluted earnings per share
* Cash flow from operations: $37.0 million

Summary of year-end results:
* Total revenue: $494.6 million, up 107% versus 2003
* Gross bookings (excluding auctions): $541.4 million, up 84% versus 2003
* B2C gross bookings: $522.3 million, up 106% versus 2003
* Gross profits: $65.8 million, up 158% versus 2003
� Cash flow from operations: $24.7 million

At first glance, there appears to be outstanding growth in this business. But look a bit closer and a couple of things immediately strike me.

- The two paragraphs list most of the key business metrics for both the quarter and the year. But wait, something is missing from the year-end summary. Oh, it's the fact that the company still lost money for the year, $5m to be precise. I find it hard to believe, in such a carefully worded press release, that this omission was unintentional
- Net Margins are very low @ approximately 1% of revenues. This is more akin to the margins of a supermarket or retailer than a "tech" company. Compare this to eBay's 23% or Amazon's 6%. But you don't find supermarkets trading @ p/e's of 185.

Now this might not be a problem, if guidance was awesome. I mean, maybe the company is just acquiring critical mass, and economies of scale going forward will mean that future revenue growth goes straight to the bottom line??? Unfortunately this is not the case. For starters, the company hasn't provided any forward guidance. This always troubles the investment community. So we are left to try to picture the future ourselves. I found this paragraph from the press release striking.

"Here is the punch-line: I now see another 250 basis points we can squeeze out of logistics, but these are, I fear, the last. Furthermore, shareholders are not going to see them: as in the coming quarters we scrape these savings out of the system, we will in one way or another pass them on to the consumer. Thus you are unlikely to see our margins rise above 15%, excluding the effects of auction and travel."

I think this is what has worried many investors. If margins are never going to improve from these very low levels the company has to grow the absolute level of revenues at a phenomenal clip in order to see anything significant at the bottom line. Compare this fore example with eBay's gross margins of 80% or Amazon's 25%.

Lets therefore try to estimate how much additional P&L the company can make for each additional billion dollars. We know that this will translate to approximately $150m in Gross P&L. How much of this gets back to shareholders depends on how much SG&A rises. Firstly, Sales and Marketing expenditure. If we look at the last five quarters, we can see a strong correlation between Sales and Marketing and Revenues.

                 31-Dec     31-Mar     30-Jun   30-Sep  31-Dec
                 2003       2004      2004     2004    2004
                ---------   -------  -------- ------- ------
Gross Revenues  123,160     82,078     87,792   103,444 221,321
S&M Expenses      9,898     4,377       6,605     9,398  20,153
% Of Revenues     8.0%      5.3%        7.5%      9.1%    9.1%
Average      7.8%                       

The only blip on this table is the March quarter but this is also the seasonally weakest quarter for the company. I think overall its fair to assume a ratio of 8% which would translate to an additional $80m in S&M expenses for our theoretical additional $1bn in revenues.

General and Administrative expenses are trickier to predict. This is the level at which most economies of scale are likely to occur since there are a number of functions included here which are for the most part fixed, and wont need to increase directly in line with increased revenues. Indeed the press release mentions this;

"We continue to build G&A ahead of our needs, but more slowly than the growth in our sales, and far more slowly than the growth in our gross margins"

Nonetheless there must be some increase since if you look at the following table, the large increase in Dec 2004 revenues has come at a certain price. At what point will they plateau however??

                31-Dec     31-Mar  30-Jun   30-Sep    31-Dec
                2003       2004    2004     2004      2004
                ---------  ------- -------- --------- -------
Gross Revenues  123,160    82,078  87,792   103,444   221,321
G&A Expenses      4,940     6,251   5,567     7,376    11,041
% Of Revenues   4.0%      7.6%     6.3%     7.1%      5.0%
Average      6.0%                       

These are actually very respectable figures when I look at other companies such as eBay (13%) and Amazon (6%). I'm therefore going to try to be conservative, and I'm going to assume that an additional $1bn in revenues increases G&A by half of the current average, or 3% ($30m).

So taking all this into account, our net margins would increase 300% to 4% (15% gross � 8% - 3%) and an additional $1bn would yield an additional $40m in net profits (before tax). I think this is a fairly optimistic scenario personally, but if this was the case, and the valuation of the company didn't change one iota, we would be saying that if the company tripled revenues next year to $1.5bn, it would be trading at a p/e of approximately 40. Not too bad you might think.

But I'm thinking the company is a few years away from growing revenues to this level. I'm thinking that I have been really giving them the benefit of the doubt in assuming a 3% rate of G&A and somewhat optimistic in assuming a tripling of net margins. I'm thinking this is before taxes. And I'm thinking I am expected to pay $66 for this now?? IMO the stock is totally overvalued and the growth premium is just too big. The gross margins of this company are very low and that is always going to make it a struggle for them at the bottom line level, no matter how efficient they are.

A couple of other things bother me. As with eBay, I don't like the stock options policy. And the recent share buyback struck me as the most brazen press release I have seen in a long time. I know a lot of companies do this but to actually admit in your press release "for the purpose of mitigating dilution from outstanding options, warrants and other convertible instruments." And the stock rallied on this??? Hello, we are buying back shares because if we don't, when we exercise the stock options we granted ourselves our eps is going to look very bad???

Finally, I know many people find Patrick Byrne inspirational, but personally, just as with George Bush, I find people who are so heavily motivated by religion or faith or values and who speak in Messianic terms just a little scary. The Noah's ark analogy is really taking the biscuit.

So from my perspective, I see two challenges in terms of profiting from what I see as a mis-pricing of risk in the stock price of this company.

Firstly, it's the admiration for Patrick Byrne, which is going to mean a lot of shareholders in this stock, will not have "weak�hands" and will not be rushing for the doors at the first sign of trouble.

The second factor that counts against shorts in this stock is the low float, much of which is held by Patrick Byrne. We have all seen with TZOO how a low float (19m shares) can lead to prices going crazy. The company has a high short interest and the poor liquidity and lack of borrow means that while the stock price will initially fall today, as long as the true believers remain strong, its going to be difficult for additional shorts to try to drive the price down and I wouldn't be surprised to see the stock finish over $60.

My position is going to take some watching at the open therefore. I purchased a straddle but with a bearish bias (2 puts for each call). My expectation is that the stock will open below $60, at which point I will look for opportunities to sell the puts. I will hold the calls then for any rebound that might occur. I will look for signs of extreme weakness however in the premarket (like eBay's recent earnings) in case it continues further downwards.


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