Description
While by no means a traditional value investment, online retailer Overstock.com offers an attractive risk/reward opportunity at current prices. Weaker than expected short-term results and CEO Patrick Byrne’s unusual behavior have made Overstock one of the most hated companies on Wall Street, with an extreme level of negative sentiment coming from sell-side analysts, major investors, and the media. While the company could be profitable, it has instead chosen to grow rapidly in order to build its brand name and establish itself as the premier website for deeply discounted goods. With the majority of Wall Street focused on Byrne and on the company’s past losses, the underlying value of Overstock is being ignored. Using a set of conservative estimates, the company can be expected to turn a profit in 2007. In addition, Byrne and other insiders have bought large amounts of stock in the past year. No matter what you think of Byrne, at current prices the potential upside is much greater than the downside.
Overstock.com is the largest internet company in the closeout retail market. It seeks to aggregate the fragmented supply and demand that makes up the liquidation market onto a single internet platform. Approximately 40% of its revenue comes from direct sales and the other 60% from “fulfillment partner” sales in which it acts as a liquidation channel for other retailers and does not actually own the products it offers. It also has small auction and travel businesses, and a unique department called Worldstock which sells handmade items from thousands of third-world artisans. The company was launched with no outside funding in 1999 and has rapidly grown revenues from $1.8 million in 1999 to $804 mm in 2005.
Overstock has lost modest amounts of money each year as it has focused on growth rather than short-term profits. 2005 results were worse than expected as the company struggled to integrate new technology after overhauling its systems. As a result Overstock’s sales and overall efficiency were significantly reduced during the second half of 2005 and the company lost just under $25 million for the year. Sales grew 63% after consecutive years of triple-digit growth. Management recently announced that it is going to slow down its growth for the first 2-3 quarters of 2006 in order to harden its systems and improve the experience of Overstock customers. In recent months the stock has fallen to its lowest levels since early 2004 and the company’s market cap is currently $444 million.
Since controversial CEO Patrick Byrne is often the first thing associated with Overstock, I will address him first and then get into the details of the business and how it will become profitable. While Byrne has taken a lot of criticism lately (some of it deserved) he is undoubtedly brilliant, shareholder friendly, and pedigreed. It is easy to take particular tidbits from recent conference calls and interviews and think Byrne crazy, however there is a lot more to him than many people believe.
The son of former GEICO chairman Jack Byrne, Patrick was mentored from a young age by Warren Buffett and considers himself a value investor above all else. Byrne’s parents let him stay home from school whenever Buffett was in town in order for him to learn from the “funny man from Omaha…” In a recent interview Byrne said “I look back and the whole trajectory of my life was changed by half a dozen conversations with him over my teenage years when he came and visited” (full audio interview can be found on www.businessjive.com). Buffett also came away impressed as he would later bring in Byrne to be the temporary CEO of Fechheimer Brothers, the Cincinnati uniform manufacture owned by Berkshire Hathaway, in 1998. The Byrne-Buffett connection is a close one, as Berkshire Hathaway is also invested in a fixed-income arbitrage hedge fund run by Patrick’s brother Mark and in 2000 Berkshire invested $300M on the ground floor of White Mountains Insurance, Jack Byrne’s latest insurance success, a stake that has more than tripled.
Aside from having a great mentor, Patrick is an incredibly smart and energetic person. Despite only being in his early 40’s, he is a 3 time cancer survivor, has a Ph.D. from Stanford, has a black belt in tae kwon do, studied moral philosophy at Cambridge as a Marshall scholar, speaks five languages, has a photographic memory, and has bicycled across the country three times. He has only spoken in detail about his battle with cancer once, but the speech he gave was pretty inspirational and worth reading if you want to understand him better before either buying or shorting the stock: (http://www.pmc.org/articles.asp?ArticleID=110). These personal tidbits do not make Byrne a better CEO, or OSTK a better stock to buy, but in aggregate they help to paint a picture of him as a fiercely independent and unique person rather than the crazy and vengeful CEO that many take him to be. He has always been an unconventional CEO. When the company launched he could not get VC funding so he decided to fund the company largely by himself. He was also one of the first to use a Dutch auction to bring the company public.
I will not address the current lawsuit against Rocker/Gradient or the naked shorting issue in detail because I have no strong opinion on how either will play out. I am happy to summarize either issue in the Q&A for anyone that is unfamiliar with them. What I do believe is that the investment community is expecting Byrne to be entirely wrong on both issues, and that those beliefs are reflected in the current stock price. I also gain some comfort in these actions because of the quality of Byrne’s inner circle of friends and advisors. At the very least Byrne is knowledgeable on the workings of Wall Street – he certainly may be wrong on these issues but he is not making them up out of thin air, or addressing them solely to take attention off of the company’s fundamentals.
Despite Byrne’s reputation as an anti-Wall Street maverick, his inner circle includes people at high levels of the business and political worlds. Aside from the obvious connections via his father, Patrick is also a director of Milton Friedman’s foundation and his brother Mark had high-level positions at numerous Wall Street firms before starting his hedge fund. Overstock’s board of directors is also an impressive group. It includes Gordon Macklin (who owns over $2.5 million of OSTK shares), a former president of the National Association of Securities Dealers, and Ray Groves, former CEO of Ernst & Young. Given these connections, you would have to believe that Byrne is not obviously wrong on these issues, although there is certainly a concern as to his focus over the near-term.
Even Jack Byrne has publicly criticized Patrick for spending too much time on these outside issues. Jack recently said that he may step down as chairman of the board, although he would stay on as a director and remain a large investor in the company. This is a major short-term risk for Overstock. Given all that he has accomplished in his life, I think it is possible that Patrick can run the company while pursuing these other endeavors in his spare time. Given his father’s criticism, however, it appears this has not been the case recently. If Patrick continues to be distracted by these issues and the company’s fundamentals do not approve he would likely step down at some point or be pressured out by the board. He was originally planning on stepping down in 2005 to pursue another opportunity, but has since decided to stay until the company’s future is clearer. At any rate it is unlikely that Byrne will be the CEO of Overstock for many years down the road. Given Wall Street’s negative view of him a change would likely be greeted as a positive development for the stock. So far the board appears to support him completely and he is likely to stay at Overstock for at least 1-2 more years. Despite this the long-term risk of Byrne losing his focus is mitigated by the fact that he would not be at Overstock for very long if he was indeed distracted and the company’s fundamentals did not improve.
At any rate, many investors have sold and/or shorted the stock largely because of a surface-deep analysis of Byrne’s recent behavior while ignoring the long-term fundamentals of the company. A good example is Mark Cuban, who says on his blog: “I am short 20k shares of the stock (Which I shorted because Patrick Byrne is CEO).”
While Byrne’s capabilities are important, the underlying strength of the company is the key to this recommendation. While often criticized for being unprofitable, Overstock could have made money long ago if it had not instead chosen to grow rapidly. In the world of ecommerce the strategy to grow as fast as possible without losing much money is the correct way to build a sustainable and profitable business for the long term. With the industry growing over 20% per year there is a massive land-grab occurring with numerous companies attempting to establish their long-term presence in the field. Only a handful of online retailers are likely to survive and those that do will benefit greatly from scale and brand recognition.
The idea of brand equity is especially important on the internet as first time shoppers are only going to buy something from a large, reputable company because of trust and security issues. Even Amazon had its fair share of doubters as it pursued a similar strategy in recent years. There is no way that it would be as profitable as it its today if it had not grown so fast and built itself into the clear leader in traditional (non-auction, non-liquidation) online retail. Because its brand equity and customer recognition are so high Amazon has been able to drastically cut back its marketing, both as a percent of revenue and on an absolute basis. Overstock is following a similar path of growth but is focused on the niche area of liquidation goods and has lost a significantly smaller amount of money than Amazon did to get to the same level of revenues. I firmly believe that Overstock is being run as any smart private owner of the business would run it – for the long term. It would be foolish to cut off its growth before the dust settles in the industry. Management has indicated that once its systems are hardened it will again step on the gas and increase its growth to well above industry averages.
While Overstock does have to compete with Amazon, eBay, and the other established retailers, its focus on the area of liquidation gives it a unique niche versus these companies. Obviously eBay gets a portion of the liquidation market, but only to a certain level of scale. Overstock’s recent announcement that it will offer products from Ingram Micro is an example of this – for a company of that size it would not be efficient to sell such a large number of products on eBay.
Overstock’s more direct competitors include companies like Smartbargains and Buy.com, both of which appear to be losing ground to Overstock. Both companies withdrew plans to go public during 2005, have significantly less revenue than OSTK, are not growing nearly as fast, and are not profitable. Smartbargains had $92 mm in revenue in 2004 (22% growth) and lost $1.5 mm for the year. Buy.com recorded $291 mm in revenue (22% annual growth) and a $15 mm net loss for the year. In addition, Buy.com CEO Scott Blum is a questionable character, having been charged by the SEC in 1997 for improperly recognizing revenue at his former company, Pinnacle Micro.
In addition to these discount websites Overstock also competes with brick and mortar retailers like TJ Maxx, Ross Stores, and Tuesday Morning. None of these companies have a presence on the web. Given that TJ Maxx shut down its website earlier in 2005 it is unlikely that any of these companies will attempt to sell products on the web in the near future. Overstock is shrewd when it comes to handling its competition and should be able to successfully deal with future competitors. Due diligence with numerous people in the industry suggests that Overstock’s recent deal with Ingram Micro was a direct blow to Buy.com’s business, which has long depended on Ingram as one of its largest suppliers. Buy.com acts purely as a “fulfillment partner” and doesn’t sell anything out of its own warehouses. It recorded 97% of its revenue in 2004 from computers and consumer electronics, and according to a recent SEC filing Ingram Micro products account for 66% of Buy.com’s orders.
As time passes the competitive advantage that Overstock has in the online liquidation market will continue to grow, largely because of brand awareness but also because of technology costs, relationships with vendors, and customer retention. Despite a market cap of $444 mm, it would cost much more than that to start a company from scratch with similar revenue, growth, technology, and brand recognition.
A recent study by Majestic Research found that Overstock was the 6th most visited website during the holidays (http://www.majesticresearch.com/Majestic_Survey_Holiday_Shopping_2005_122005.pdf). Perhaps more importantly, the study also found that 71% of Overstock’s visitors came to the site by typing in its URL directly into their browsers, rather than coming through search engines or affiliate programs. This suggests that the company’s brand is very strong and that its revenues will hold up as advertising is scaled down.
While there are no perfect comps for Overstock, a quick look at the best available competitors shows that the market is discounting Overstock’s shares significantly if you believe the company will eventually be profitable.
Price/ Est. 2006 Price/Gross 2005 Gross
Mkt Cap Sales Sales Growth Profit Profit Growth
Amazon $15.4 B 1.81 19% 1.9 28%
TJ Maxx $11.7 B 0.73 8% 3.1 7%
Ross Stores $4.1 B 0.86 11% 4.2 15%
Tuesday Morning $896 mm 0.96 8% 2.5 5%
Blue Nile $586 mm 2.89 27% 13.0 20%
Overstock $444 mm 0.55 26% 3.7 84%
Once again, there is no one company that is a perfect comparison for Overstock and price/sales and price/gross profit aren’t perfect metrics, but with the lowest P/S, an average P/GP, and the highest growth in the group, OSTK’s potential upside appears significant. Amazon obviously deserves higher multiples. Online jeweler Blue Nile does as well because it is profitable, but with a third of the revenue, a weaker brand name, and slower growth it’s hard to imagine why its market cap would be 50% higher than OSTK’s. TJ Maxx, Ross Stores, and Tuesday Morning all have higher P/S ratios and similar P/GP ratios, despite Overstock’s growth being significantly higher.
Now a closer look at Overstock’s numbers. Overstock’s long-term success or failure will largely depend on two things: gross margins and the percent of revenue spent on sales and advertising (S&M). General and administrative expenses (G&A) as well as technology costs are also important and may impact short-term results, but over time these expenses should be scalable and decrease as a percent of revenues. When Amazon crossed the $1 billion in revenue mark in 1999 it spent 14% of its revenue on G&A plus tech. That combined number decreased each year until 2004 when it hit 5.2%.
As for gross margins, I expect them to increase modestly going forward. There is a large benefit of scale for a company like Overstock that buys other retailers’ excess inventory. The ability to step in and offer to buy a retailer’s entire excess inventory is a huge bargaining chip and Overstock is just now getting to that point with many retailers. OSTK’s gross margins were up 270 basis points in 2004 and 170 in 2005. Amazon North America’s gross margins have also increased as it has grown (excluding fulfillment costs: 16.8% in 2002, 17.2% in 2003, 17.9% in 2004, and 18.1% in 2005). Clearly size has its benefits in both online and closeout retail.
To show a wide scope of possible outcomes, I will offer three scenarios for Overstock’s numbers through 2009. The company’s exact path is hard to predict due to its dynamic growth and recently-changed plans for 2006. What these numbers do show is that slight gross margin expansion and a gradual decrease of operating expenses as a percent of revenue will make the company significantly profitable at some point in the next few years. Exactly when this will occur is difficult to know, but the upside is attractive even in the most conservative scenario. The potential downside for Overstock is limited given it strong brand name, large base of revenues and gross profits, and depressed enterprise value of $416 million.
In the conservative scenario revenue growth is estimated at 21% for 2006, which assumes 15% growth for Q1-Q3 and 30% for Q4. The average street estimate is currently 26%. Overstock management has said that G&A plus tech will be between $90 and $100 million for 2006; I estimate it at $103. S&M as a percent of revenue is estimated to decrease 2%; management has said it will decrease 2% to 3%. To put this in perspective, Overstock spent $80 mm on S&M in 2005 and its revenue increased $309 mm. This scenario assumes it will spend $77 mm on S&M and increase revenue by just $169 mm in 2006. Gross margins are estimated to increase 50 basis points in both 2006 and 2007 before leveling off at 16%. Despite these conservative estimates Overstock is essentially break even in 2007 and becomes solidly profitable after that.
Conservative Scenario:
2005 2006 2007 2008 2009
Revenue $804 $973 $1,216 $1,459 $1,678
Revenue Growth 63% 21% 25% 20% 15%
Gross Profits $121 $151 $195 $233 $269
Gross Margin 15.0% 15.5% 16.0% 16.0% 16.0%
S&M $80 $77 $84 $88 $92
% of revenue 9.9% 7.9% 6.9% 6.0% 5.5%
G&A $36 $49 $49 $51 $50
% of revenue 4.5% 5.0% 4.0% 3.5% 3.0%
Tech $28 $54 $61 $66 $67
% of revenue 3.5% 5.5% 5.0% 4.5% 4.0%
Total Oper. Exp. $144 $179 $193 $204 $210
Oper. Profit ($23) ($28) $1 $29 $59
Oper. Margin (3.0%) (2.9%) 0.1% 2.0% 3.5%
The next set of numbers is a middle of the road estimate using more average estimates. Revenue growth is 26% for 2006, the average street estimate, and decreases each year after that. G&A plus tech is $100 mm, the high end of management estimates. Gross margins expand slightly more than in the conservative scenario and operating expenses as a percent of revenue decrease slightly faster.
Average Scenario:
2005 2006 2007 2008 2009
Revenue $804 $1,013 $1,266 $1,551 $1,861
Revenue Growth 63% 26% 25% 23% 20%
Gross Profits $121 $159 $205 $256 $307
Gross Margin 15.0% 15.7% 16.2% 16.5% 16.5%
S&M $80 $75 $81 $93 $102
% of revenue 9.9% 7.4% 6.4% 6.0% 5.5%
G&A $36 $49 $51 $54 $56
% of revenue 4.5% 4.8% 4.0% 3.5% 3.0%
Tech $28 $51 $61 $67 $74
% of revenue 3.5% 5.0% 4.8% 4.3% 4.0%
Total Oper. Exp. $144 $174 $192 $214 $233
Oper. Profit ($23) ($15) $13 $42 $74
Oper. Margin (3.0%) (1.5%) 1.0% 2.7% 4.0%
The final set of numbers is the optimistic scenario, incorporating higher revenue growth, an increase in gross margins to 16.5% by 2007, and slightly faster decreases in operating expenses as a percent of revenue. While certainly optimistic, this scenario is not impossible. By 2009 Overstock would spend 5.5% of its revenue on advertising; Amazon currently spends 2.3%.
Optimistic Scenario:
2005 2006 2007 2008 2009
Revenue $804 $1,013 $1,368 $1,778 $2,222
Revenue Growth 63% 26% 35% 30% 25%
Gross Profits $121 $162 $226 $293 $367
Gross Margin 15.0% 16.0% 16.5% 16.5% 16.5%
S&M $80 $70 $88 $107 $122
% of revenue 9.9% 6.9% 6.4% 6.0% 5.5%
G&A $36 $46 $55 $62 $67
% of revenue 4.5% 4.5% 4.0% 3.5% 3.0%
Tech $28 $49 $62 $71 $78
% of revenue 3.5% 4.8% 4.5% 4.0% 3.5%
Total Oper. Exp. $144 $164 $204 $240 $267
Oper. Profit ($23) ($2) $22 $53 $100
Oper. Margin (3.0%) (0.2%) 1.6% 3.0% 4.5%
With these numbers I find it no surprise that company insiders have bought large amounts of stock in the past year. While some argue that Patrick Byrne’s purchases are deliberate attempts to squeeze shorts, he is not the only one buying. Jack Byrne, whose intentions and investment acumen can not be questioned, made large purchases as recently as August. He even sold some of his shares in White Mountains Insurance within weeks of buying Overstock. Current director and former officer Jason Lindsey has also bought shares. Lindsey is very close to Byrne and was briefly the president of the company before having to leave because of a family health issue. Patrick’s recent description of Jason is important: “He, I’d say, built the Company at least as much or more than I did...He’s much more conservative than I am. I think he’d like to see us throttle back to 20% growth and start spitting out $40 or $50 million. And I’m not sure he’s wrong about that…” This was said before the company announced its plans to indeed slow its growth, so apparently Lindsey’s conservative approach is having some influence on Byrne and the rest of Overstock’s management.
These company insiders not only bought large amounts of shares, but they did so at significantly higher prices from where the stock currently trades. In November Jason Lindsey bought the stock at over $33, Patrick Byrne has bought shares for up to $48, and even Jack Byrne has bought shares for as high as $54 in the past year.
In addition to these insider purchases, the company itself has bought back a large amount of shares as the stock has fallen. This looks particularly shrewd given that Overstock issued new shares and converts in late 2004 and early 2005 when the stock was in the high 50’s and 60’s. The convert offering, for example, occurred in February 2005 when the stock was at $53, and the notes have a conversion price of over $76/share.
Also worth noting is that Scion Capital and Fairfax Financial Holdings, both respected value investors, recently purchased large stakes of Overstock. Scion owned over 8% of the company as of 12/31/2005 and Fairfax has bought a similar amount since year-end.
Risks:
-Patrick Byrne continues to be distracted by the Gradient lawsuit and naked shorting issue
-Economic/retail slowdown. Always a short-term risk, although Overstock would likely benefit in the end as it would have more opportunities to buy products from distressed sellers
-Continued “growth pains” such as recent technology integration
Catalyst
Catalysts:
-Value is its own catalyst
-Continued insider buying
-Increased brand awareness and scaling down of marketing leads to profitability
-Unlikely, but possible catalysts (free call options) – auction or travel businesses catch on, Byrne is correct on lawsuit and/or naked shorting issues and the company gets free publicity