Overstock Declares War on Online Retail

Overstock.com (Nasdaq: OSTK) wants to lower your prices for online shopping. In his recent Investors Business Journal interview, CEO Patrick Byrne stated that his mission was to squeeze out costs and pass the savings to customers. Byrne aims to position Overstock as the low-cost leader in online retail. When asked about the inevitable competition with Amazon.com (Nasdaq: AMZN) for that top spot, he said only, "Let the games begin."

Of course, lowering prices is not an act of pure benevolence. Sometimes, it can be a savvy business maneuver. Costco (Nasdaq: COST) retail warehouses have thrived by offering the lowest prices, then selling them in large amounts. Overstock hopes to succeed through a similar online strategy.

So why is Wall Street giving Overstock the cold shoulder? After the company reported a 32% increase in revenue in its second-quarter results, Wall Street sent Overstock shares into a tailspin. The stock now languishes 48% below its 52-week high.

Analysts had three main concerns:

• Overstock booked a net loss of $1.4 million for the quarter.
• Trailing-12-month free cash flow dropped.
• Revenue growth came in below Wall Street's expectations. 

All three are valid points, and from a certain point of view, Overstock's recent earnings do reveal disturbing business trends. Yet from another perspective, the company's doing exactly what you'd expect from a retailer following a low-price strategy.

For example, in the latest quarter, gross margin declined by 270 basis points year over year. This means the company is taking a lower gross percentage from its average customer order. Is competition forcing Overstock to lower prices just to survive, or is the company willingly cutting prices to attract more customers and business?

Analysts also closely watch Overstock's trailing-12-month free cash flow. Over the first six months of this year, that figure has dropped consecutively -- but why?

Overstock now holds more in inventory, and it's investing more in capital expenditures. While both figures crimp free cash flow, the motives behind those moves can be interpreted in wildly different ways. Is Overstock clinging to old and obsolete inventory, or simply preparing to sell more in the coming three months? Similarly, do the recently higher capital investment amounts represent the real norm, or is Overstock funding new projects and ventures as business improves?

By the numbers
Financials can't always reveal the reality of questions like that. But sometimes, other pieces of data can clue us in to the truth. If sales are any indication, Overstock's low-price strategy is definitely beneficial:

Q2 2010 Online Sales

Source: comScore.

The online retail industry grew by 9% overall in the second quarter, according to data calculated by comScore. Overstock's sales grew by 32%. So although its revenue growth rate trailed that of Amazon, Overstock still seems to be gaining market share in online retail.

The Foolish bottom line
The future of the online marketplace will be global and huge, and retailers everywhere have taken notice. Eddie Lampert, the Sears Holdings (Nasdaq: SHLD) CEO, even called his company's website a top business priority at his recent shareholder meeting.

Companies have formed a variety of strategies to capitalize on this opportunity. eBay has used the strength of its marketplace to raise fees and boost returns. Wal-Mart (NYSE: WMT) has adapted a model that combines online presence with the convenience of its stores. MercadoLibre (Nasdaq: MELI) avoided the U.S. entirely, operating instead in Latin America, where competition has been scarce.

Overstock's low-cost strategy could lead it to gain market share, build up competitiveness, and earn the company significant operating returns. Alternately, its brand might never gain recognition, dooming the company to sputter along, never establishing itself as a formidable online threat.

In the next few quarters, we'll get a much clearer picture of which outcome seems more likely.