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On Overstock

Why am I writing about an unprofitable internet company on a value investing blog? Because this blog is about finding dollars that trade for fifty cents; with a market cap of less than 75% of sales, Overstock.com (OSTK) looks like it may be exactly that.

But isn’t it too risky?

The greatest risk in any investment is the risk of overpaying. So, the real question is: what is Overstock worth? I think it’s worth at least $1.5 billion. With Overstock’s market cap currently sitting around $500 million, my valuation certainly looks far fetched. But, there’s only one way to know for sure. Let’s take apart my argument piece by piece, and see if any of my assumptions are unreasonable.

First Assumption: Over the next five years, Overstock will neither generate truly free cash flow nor consume cash. In other words, its free cash flow margin will average 0%. Cash generation in some years will exactly offset cash consumption in other years. Obviously, this assumption is unreasonable, because there is almost no chance the cash flows will exactly offset.

That’s not a problem if it turns out Overstock does generate some free cash flow over the next five years. In that case, my assumption simply errs on the side of caution. If, however, it turns out Overstock actually consumes cash over the next five years, there is a problem – possibly a very big problem. So, which scenario is more likely?

Overstock’s revenues are growing quickly. Gross margins look solid at 13.3% in 2004 and 14.9% over the last twelve months. Overstock’s unprofitability is the result of its selling, general, and administrative expenses (SG&A;) which have been growing exponentially. Will these expenses continue to grow? Yes, but not as fast as revenues. Over the last twelve months, Overstock’s spending on cap ex has been 5.6% of sales. That number is an aberration. In the long run, spending on cap ex should not exceed 3% of sales. Considering the business Overstock is in and the expected sales growth, the company will, more likely than not, generate some free cash flow over the next five years. Therefore, the assumption that Overstock will be cash flow neutral over the next five years is not overly optimistic.

Second Assumption: Over the next five years, Overstock’s sales will grow by 15% annually. Is this an unreasonable assumption? Again, I don’t think it is. Very few industries are expected to grow as fast as eCommerce. Overstock’s revenue growth in 2003 and 2004 was over 100%. In the past year, that growth has slowed. However, it is still closer to 50% than it is to 15%. Overstock isn’t in a cyclical business. So, there is no reason to believe current sales are abnormally high.

Also, all that spending on advertising is increasing consumers’ awareness of Overstock. A review of Overstock’s traffic data shows it has not only been gaining more visitors; it has also been climbing the ranks of the most popular web sites. …

Microsoft vs. eBay

Which company has the wider moat? Vote for Microsoft (MSFT) or eBay (EBAY) by sending an email to [email protected]. Include a brief explanation of your thinking on the issue.

If your vote is the most interesting email of the entire contest, you’ll win a copy of Benjamin Graham’s “Security Analysis”.

The voting for Microsoft and eBay closes at midnight on Monday (12:01 a.m. Tuesday).

Vote now by sending an email to: [email protected]…

Contest: Microsoft defeats eBay

With 67% of the vote, Microsoft (MSFT) defeats eBay (EBAY). Microsoft will advance to the next round to face a yet to be determined opponent.

I am in complete agreement with the description given by one of the voters (Soo Chin):

This fight is like Joe Frazier vs. Mohammad Ali… Two great heavyweights, but there can only be one winner.. in this case.. the Mohammad Ali of business — Microsoft.

Thank you to everyone who voted. I hope you’re enjoying the contest. The next podcast with two more picks should be available within the next 48 hours.

Congratulations to Microsoft (and George of Fat Pitch Financials).…

On Lexmark

At the end of my very first podcast, I mentioned my positive experience with the investor relations people over at Lexmark (LXK). They sent me the company’s annual reports for 1995 – 2004 as well as the accompanying 10-Ks. This happened over two weeks ago; so, I’ve had plenty of time to review the material. But, until now, I haven’t written a word about Lexmark. Why?

In 2005, Berkshire Hathaway bought about a million shares of Lexmark. I haven’t followed this story closely, but I assume the stock was purchased by Lou Simpson rather than Warren Buffett. I have only two reasons for believing this: the total purchase was small relative to Berkshire’s investable assets and the Lexmark purchase is typical of Simpson’s investment philosophy (or at least, what little I can glean about his investment philosophy from his past purchases). Regardless of who actually makes the purchases, a new Berkshire holding always draws a lot of commentary.

The commentary on Lexmark has been almost uniformly negative. Even many value investors have a very dim view of Lexmark at these prices. Now, I am not a contrarian investor. Psychology and sentiment do not enter into my considerations at all. I’ve bought stocks trading near five year lows, and I’ve bought stocks trading near five year highs. I just try to be rational. I’m not afraid to agree with the consensus, if it’s an accurate representation of reality. Here, it isn’t. The model of Lexmark that has emerged in my mind over the past few weeks bears little resemblance to the Lexmark I’ve seen described elsewhere.

Most of the negative comments about Lexmark have focused on the consumer segment. Yet, more than 75% of Lexmark’s profits come from the business segment. The business segment is Lexmark’s franchise. There, the company has managed to build a moat, not a very wide moat, but a moat nonetheless. Lexmark is the only focused, integrated printing company of any consequence. It understands its business customers’ needs, and provides specially tailored solutions that none of its competitors can offer.

Worldwide, some very large companies use Lexmark’s products for some very specialized tasks. Among these are retailers, banks, and pharmacies. Lexmark has complete control of their product including the printing technology itself and the software used to manage its printers (i.e., to interface with the user’s computer). Businesses that care about getting these specialized tasks done right (and getting them done cheap) use Lexmark.

Even Lexmark’s competitors have to concede the fact that Lexmark knows printing better than anyone else. Lexmark is the only company that develops its own ink – jet, monochrome, and color laser technologies. It is a vertically integrated printer business like no other. The two competitors most often mentioned as threats to Lexmark are HP and Dell. While everyone will suffer from deep price cuts; I think it’s HP and Dell who should be scared.

Lexmark has the much stronger competitive position. For years to come, it will …

On the New Podcast Episode

The new podcast episode “Competitive Advantage” is finally up. It’s the one that was originally scheduled for Tuesday. I’ll try to get another episode out real soon, so I can get back on schedule. Whenever there’s a delay like this, you can still count on getting two podcasts each week – that’s my promise to you. I know most of you aren’t listening to each podcast the moment it comes out anyway, so I hope this hasn’t been too much of a disruption. Anyway, I apologize for the delay, and hope you enjoy the new podcast.

Also, I want to thank everyone who sent in entries for the widest moat contest. The two picks I drew for this week were Microsoft (MSFT) and eBay (EBAY). If your pick isn’t one of these two, don’t worry, it’ll be featured on an upcoming podcast.

Don’t forget to vote for either Microsoft or eBay. The voting for these two picks will close at 12:01 a.m. on Tuesday. On next Tuesday’s podcast, I’ll let you know which one was eliminated and which one will move on to the next round. Remember, you can cast a vote by emailing [email protected].

To make your own pick for the widest moat contest leave a voice mail at 1 – 800 – 782 – 1687. Contest entries will be accepted through Friday, January 20th. Don’t forget each person is allowed two picks.

Enjoy the podcast.…

On Korean Stocks

I wanted to direct you to an interesting post over at Shai’s blog: “Warren Buffet’s Comments on the Korean Stock Basket”. I had been looking at Korean stocks previously, but did not see a way to own a diversified group of the cheap ones (that would be impossible via ADRs). Also, having spoken to several Koreans, (I should note these were people who chose to immigrate to this country or chose to attend school in this country, so they may be biased), I was not reassured about corruption issues over there. However, I think, with such a wide margin of safety present in each stock purchase, diversification would have been enough to manage the risk of corruption. Anyway, it’s an interesting post because it again emphasis the importance of looking where others aren’t, and because it offers a glimpse of Warren Buffet’s thinking.…

On Value Investors vs. Growth Investors

As you wait for today’s podcast, please check out a great post on value investors vs. growth investors over at RVB’s Market Musings.

It’s too easy to become wed to one particular philosophy, instead of remaining open to reason wherever it comes from. Even though the words value investing are plastered all over this site, I can’t afford to ignore a good idea simply because it comes dressed in the garb of another investing school. Being a value investor is about remaining true to a few core principles; it isn’t about adhering to dogma.

That’s why I’ll often mention Phil Fisher right there along with Benjamin Graham. Pretending the two are separated by an unbridgeable chasm won’t do you any good. There is value in both men’s writings. Likewise, there is value in a few of the best ideas of growth investing. Just don’t compromise on those core principles when you look to broaden your horizons.…

On Sanderson Farms’ Big Bet

Today, Value Discipline noted that Sanderson Farms (SAFM) is not as concerned about the chicken cycle as analysts are. This fact is evidenced by today’s announcement of a new capital project. If you’re interested in SAFM, you’ll want to read the post at Value Disipline.…

On Blogs as Public Records

I read something worth sharing. It’s a comment to a post on Shai’s blog. In it, Bill of “Absolutely No DooDahs” wrote:

On blogs – not only are they private thinkpads, but public ones. Someday years from now, someone’s gonna look at these blogs, where we (some of us, anyway) go out on a limb, and either say “what a genius” or “what was HE smoking.” I know that I look back on what I’ve written, here and in other places, and try to learn from my incorrect assertions and appreciate my correct ones. If my ideas prove to be successful – the blog may make a heck of a resume. If not, well, I should keep my day job.

This is exactly right. I know you may want more in the way of stock picks, but that isn’t what this blog is about. I’m never going to be able to do some sort of “lighting round” here; nor, would any such segment be of use to you. I like to have good reasons for making any assertion. I also like to make them once and make them for the long run. So, when I said I thought SAFM was the better buy than PPC, you can and should hold me to that. When, on my podcast, I said I thought it was a good bet CRFT and VLGEA would outperform the market, I meant it. If I end up being wrong about those things, tell me. We’ll go over my mistake. Think of it as an autopsy. We’ll determine the cause of my error, and look to prevent it from creeping into our thinking in the future. When I decided I wanted to create this site, the first thing I did was scribble down a real simple “mission statement” in my notebook: Help you become a better investor.

Learning from my mistakes will help you become a better investor, so however unpleasant it may be for me, it’s a necessary part of this project. Don’t let me get away with anything. I don’t want this to be the kind of place where something is said and then just allowed to drift off into the ether of web. A long term investor needs a long memory.

Visit Absolutely No DooDahs…

On the Widest Moat Contest (again)

Just a reminder:

You can win a copy of Benjamin Graham’s “Security Analysis” (1940 edition)

All you have to do is:

Pick the public company you think has the widest moat and leave a voice mail with your name, the name of the company you’ve picked, and a brief explanation of why you picked that company at: 1 – 800 – 782 – 1687

(You can pick up to two companies. If you do, leave two separate voice mails, one pick per message)

I will randomly pair off all the voice mail picks and put one pair into each upcoming podcast. Listeners will vote (via email) for the one with the widest moat from each pair. The pick with the fewest votes will be eliminated. This process will continue until only one company is left. Listeners will include a brief explanation for their vote with each email. The listener who sends in the most interesting email will also win a copy of Ben Graham’s “Security Analysis”.

Good luck.…