Description

How does a stock go down 90%? It goes down 80% and gets cut in half. How does a stock go down 95%? It goes down 90% and gets cut in half.

As many short sellers will attest, the best shorts are often better shorts after they are already down 50%. (cc: Eiffel Tower)

Enter Overstock.com: a struggling ecommerce retailer that caught the crypto/blockchain tiger by the tail. The stock was a six bagger from June 2017 to January 2018, moving from $15 to $90, but has since crashed to $38. I believe the stock is a better short at $38 than it was at $85 and OSTK is headed to $15 or lower over the next few months.

The bull case on OSTK was predicated on two points;

1. The retail business was valuable and worth more than the current market cap.
2. OTSK’s blockchain ventures (tZERO and others) were free call options on the disintermediation of major segments of the financial service industries (investment banking, stock trading and lending, etc.) using new technologies.

There were two primary catalysts that were going to help realize this value; 1) the sale of the retail division, and 2) a $250-$500mm tZERO token offering. Bulls believed a tZERO ICO would result in tradeable tokens that could only go up in price (not shortable, low float, easily manipulated) which would help crystalize the multi-billion dollar valuation of OSTK’s blockchain ventures, and hence justify OSTK’s elevated stock price.

I believe this bull thesis has been busted over the past two months.

Apologies to investors looking for a comprehensive history of OSTK, its controversial CEO, its most vocal proponents, and a play by play of what happened in 2H17. This is an abbreviated write up meant to summarize the slew of negative information recently released and why I believe the stock will continue its unwind.

Retail business

Overstock’s home furnishings eCommerce business has grown below the pace of industry eCommerce growth every year for the past decade. The business is mature and has been publicly traded since 2002. Due to below average sales growth, weak gross margins (~17%), razor thin EBITDA margins (~1-2%) and very little FCF generation, the stock has generally traded in the price range of $10-20 for a decade.

Nevertheless, bulls believe OSTK is too cheap and that OSTK is a high-quality eCommerce company deserving of a sales multiple inline with Wayfair and Amazon. At 1.6x multiple (Wayfair’s LTM EV/sales multiple) on $1.8b of sales = $100 for OSTK. The comparisons to Wayfair and Amazon, both of which are rapidly growing, along with the use of LTM sales multiples are absurd.

OSTK’s CEO Patrick Byrne hired Guggenheim in December 2017 to sell the eCommerce business and the business is still being shopped.  All old news. What is relatively new, as of the reporting of 4Q17 results on March 15, is that OSTK’s retail business is getting crushed by Wayfair, WMT/Jet and Amazon. OSTK sales are declining double digits and EBITDA margins are negative and getting worse.

To make matters worse, OSTK announced it is pivoting its strategy to compete with W and AMZN. They want to adopt the grow at any price model and think they can do so “far better and more efficiently” because “we're the most efficient e-commerce engine out there”.  “We have radically shifted our strategy for the first time in our 18 years...We're going to play who lose the money.” My channel work on OSTK’s retail business suggest a vastly inferior business model with lower quality customers vs. peers.

With $203mm of cash on the balance sheet bulls likely think OSTK can easily fund their investment in growth. A deeper look suggests otherwise. This cash is offset by $171mm of accrued liabilities and accounts payable + $47mm of deferred revenue + $40mm of debt. Total net working capital less debt is just +$10mm. Not a lot of wiggle room.

The 10-K also had a couple interesting tidbits: OSTK paid off their $44mm term loan (at LIBOR + 2%) with a $40mm loan from the CEO’s mother and brother at 8%, which is due in 18 months. Why? No idea. Maybe OSTK needs to keep its $45 term loan and $25mm credit facility open ‘just in case’. In addition, the company announced an SEC investigation into the tZERO ICO and FINRA investigation into tZERO’s officers and activities.

Fast forward ten days after the 4Q17 results and OSTK shows us some more cards. On 3/26/18 they announced a 4M share offering with Guggenheim as the lead manager, the same bank that is supposed to be selling the retail division. Meanwhile OSTK is still shopping a $250+mm tZERO deal - more on this later. Something clearly doesn’t add up. The prospectus had some new dirty tidbits; 1) the secondary proceeds would first be used to pay back the $40mm to the CEO’s mom and brother, 2) tZERO ICO proceeds may have to be recognized as taxable income (although no update as to if it was happening), and 3) 1Q17 results were tracking towards a pretax loss of $50mm ($35mm from eCommerce and $15mm crypto/blockchain). The loss was 2x the consensus expected loss despite an earnings call ten days earlier, which was a ridiculous call. In addition, the company did not provide revenue guidance which suggest sales declines have gotten worse, despite the increased spending and cash burn.

On March 29th the equity offering was cancelled. Bulls like to believe the CEO made a smart decision to not sell shares at a depressed price, but conversations with Guggenheim suggest otherwise. The best deal Guggenheim could put together after three days of marketing was $75mm at $32 per share. This would have been a significantly downsized deal (half sized) and priced 13% in the hole for a stock that had already declined 18% since the deal was announced. OSTK had to decline the deal to save face. Ouch.

The attempted offering sends many negative signals:

• The CEO called the deal opportunistic financing suggesting the stock is overvalued.
• The retail sale and tZERO ICO are unlikely to be happening anytime soon, if at all.
• There was/is no institutional support or interest in owning the stock - Although Soros and Passport purchased OSTK warrants earlier in 2018 it does not appear they wanted to participate in the offering even at lower prices.
• OSTK might need the money much sooner than later. They consequently postponed contributing to one of their blockchain investments shortly after the offering was cancelled. eCommerce results are continuing to get worse.
• There is likely a ceiling on the stock since there will be an expectation OSTK will do an offering if the stock trades back into the low 40s.

Blockchain ventures

Overstock’s efforts to develop and advance blockchain technology are under a subsidiary called Medici Ventures. It is a scatter shot / venture capital approach where Medici owns stakes in many different companies focused on six key emerging crypto-industries; capital markets, money and banking, identity, land, voting, and underlying tech. See Bryne discuss some of these initiatives with Vice News.

“Disruptive” ideas capture investors’ imaginations, but for OSTK the reality is a majority of their cyypto investments are insignificant. The Company has minority interests (<20%) in seven companies (PeerNova, Factom, Ripio, SettleMint, IdentityMind, Symbiont, and View) that had a carrying amount of just $6.5mm at YE17. While Bitcoin skyrocketed in value in 2017, OSTK’s crypto investments suffered a $5.5mm impairment in 2017. Three additional companies (Bitt, Spera and Voatz) are accounted for using the equity investment method and are carried at $6.5mm. But what about the hidden crypto value? Cryptocurrencies were just $1.5mm as of Dec17.

Not surprisingly, there have been numerous ridiculous claims made over the past nine months about OSTK’s blockchain initiatives - some by the Company, others by fans. Fortunately for readers I don’t have the time or interest in picking apart these comments. Most of these companies have yet to bring anything to the table other than a story. Color me skeptical. And while I like to keep an open mind, my views are generally closer to Kai Stinchcombe’s (Blockchain is not only crappy technology but a bad vision for the future, Ten years in, nobody has come up with a use for blockchain) then to any believers.

Overstocks largest blockchain investment of about $30mm is tZERO - a financial technology company that bulls believe will disintermediate the entire banking industry by replacing money with crypto, capital raises with ICOs and stock lending with a blockchain ledger to avoid naked short selling (how is this still a problem?) and improve stock borrow transparency.

My conversations with stock loan participants suggest tZERO is not a real threat and the industry is working towards improved transparency - not because of pressure from tZERO but because the market is  headed in this direction. Improved stock loan price transparency is the primary value-add of tZERO. Are Patrick Byrne and a $30mm investment really going to topple Goldman Sachs? There are plenty of new ICO trading platforms and there is little unique about tZERO. At today’s price ($36 stock, ~$1.1b market cap), the market appears to be valuing OSTK’s blockchain ventures, primarily tZERO, at about $750mm. Good luck.

tZERO first announced its ICO last October, but over six months later, we still do not have an ICO. The tZERO filings suggest the company has struggled to find investors to hit their $250mm goal.

A week after its latest update in February 2018, OSTK posted an updated tZERO prospectus on OSTK’s SEC website. The old prospectus had been difficult to get via the tzero.com website - investors had to go through lengthy process to prove they were accredited investors including passport photos. In this new prospectus OSTK disclosed some additional details around the tZERO token offering; 1) tokens aren’t transferable or sellable for a minimum of 1 year (and that’s only if tZERO authorizes peer-to-peer transfers, and 2) tokens can only be transferred onto a designated trading system after one year (the platform does not currently exist) only if tZERO is successful in creating that platform.

Basically, there is a one year lock-up, tokens will not be tradable for at least a year (if at all), and investors could be stuck holding tokens they can’t ever sell. This completely negates the bull thesis that OSTK shares will be tied to a tradeable tZERO coin price that will become wildly inflated in value and make OSTK shares look cheap.

Because of the new information in the prospectus tZERO added a withdrawal right which gave everyone that had committed capital the opportunity to back out within five days of the new filling. We haven’t gotten any updated commitment numbers since this filing and the tZERO ICO might not happen as crypto and bitcoin enthusiasm seems to be fading with bitcoin now trading below $7,000.

Conclusion

My thesis is the OSTK story is broken. OSTK’s retail business is in freefall and is unlikely to be sold at the price bulls are hoping for, which means it is unlikely to be sold at all. In addition, OSTK’s change in eCommerce strategy will present liquidity challenges for the company in 2H18. As for the extracurricular activities, enthusiasm around cryptocurrency and blockchain is waning. The tZER0 ICO is unlikely to happen given constraints not imagined when OSTK was trading above $75. Even if the ICO is successful, the potential for taxed proceeds and a year trading restriction for a hot money idea is vastly different then what bulls envisioned. Medici Ventures will have to deliver real results and it will take years, and potentially a lot of money, before there is a real product generating sales.

I believe this retail-pumped rocketship will complete its Eiffel tower formation over the next few months and head to $15 or lower. With EBITDA negative and declining, we have to use a sales multiple/SOTP to value. A 0.25x sales multiple (previous average) on $1.7b of sales + crypto ventures at cost = $15 stock.

Catalyst

Weak quarterly results

tZERO ICO ore eCommerce sale cancelled

Crypto/bitcoin enthusiasm wanes

Risks: higher crypto prices (OSTK sometimes trades as a proxy), tZERO ICO a success, eCommerce sale at attractive prices.