On Overstock’s Fourth Quarter
I know some of you would rather I didn’t keep posting on Overstock. Unfortunately for you, I think it’s one of the best bargains out there. So, I’m following up on Overstock by breaking down the results of Q4. All quotes are from Overstock’s President, Patrick Byrne.
For those who hate these Overstock posts, you’ll be happy to hear I plan to post an analysis of the Journal Register Company (JRC) tomorrow.
On Tuesday, February 7th, Overstock.com (OSTK) reported its fourth quarter revenue and full year financial results. The headline numbers were a net loss of $25 million or ($1.29) per share for 2005 vs. a net loss of $5 million or ($0.29) per share in 2004, and total revenue for 2005 of $804 million vs. total revenue for 2004 of $495 million.
For the year, revenues grew by 63%. The rate of growth decelerated throughout the year. Revenue growth was 102% in Q1, 72% in Q2, 64% in Q3, and 44% in Q4. Management expects revenue growth to be much slower in 2006. “During this time that we are hardening our new systems, we will reduce growth to industry rates. Our emphasis in 2006 will be on an improved customer experience – – even if at the expense of growth.”
The three most important figures to watch in evaluating Overstock are revenue growth, gross margins, and traffic data.
Overstock’s traffic data for the fourth quarter of 2005 was encouraging. As one would expect, most of the traffic to Overstock came in the first half of December. Overstock’s traffic numbers were strong in both absolute and relative terms for the first three weeks of December, and then dropped off very sharply thereafter. Notably, Overstock achieved its highest traffic rank to date during the Christmas shopping season. The trends in Overstock’s fourth quarter traffic data were consistent with those found in other major online retailers. Traffic data should be treated as a qualitative rather than a quantitative consideration. It is most useful as a negative indicator. There was nothing troubling in Overstock’s fourth quarter traffic data; so, it adds little to the present discussion.
Overstock’s revenue growth for 2005 was also encouraging. For the year, revenue grew by 63%. My $1.5 billion valuation of Overstock was based on a five year annual growth rate of 15%. Revenues will grow much more slowly in 2006. The deceleration in revenue growth throughout the year neither surprises nor alarms me.
Management entered 2005 with some very high growth expectations. “I said that my goals in 2005 were to grow revenues 60-100% and break even +/- 1%. We achieved the first, but I failed on the second. 2005 started fairly well, but ended weakly.” I did not share management’s expectations, and thus was quite content with the growth achieved.
Overstock’s average customer acquisition cost increased 33%. This looks like an alarming number, but a closer look at the company’s financial results suggests the increase was largely unnecessary, or at least, not economically attributable solely to 2005.
GAAP accounting causes this problem for some businesses like Overstock, because advertising expenses are matched with only a part of the total revenues they eventually create. Some analysts prefer to capitalize advertising and R&D; expenses over a period of 3 years or so. I don’t see any logical way to determine the appropriate useful life of such speculative intangibles, and therefore do not capitalize these expenses. I do believe, however, that Overstock’s true customer acquisition costs are somewhat overstated this year and will probably be somewhat understated next year.
I believe certain online advertising prices are unsustainable. However, this is not an area about which I am knowledgeable; so, I try to err on the side of caution. My concerns about unsustainable online ad rates have caused me to reduce my intrinsic value estimates for those companies that generate revenue from such ads; however, for the purposes of my analysis of Overstock, I have assumed online ad rates are sustainable. I believe this is the most prudent course of action.
Overstock’s gross profits rose 83% to $121 million. Gross margins in 2005 were 15% vs. 13.3% in 2004. As I stated previously, I believe 15% is the absolute upper limit for Overstock’s gross margins. If gross margins were to rise above 15% for any real length of time, I would be concerned that Overstock was overpricing its inventory. I expected gross margins of about 15% for the year. Such margins are consistent with Overstock’s recent performance. However, I would not mind seeing a slight decline in gross margins during 2006. Sustainable gross margins of 12-15% would be ideal.
The 83% rise in Overstock’s gross profits was far better than I had anticipated. Gross profits of $121 million highlight the ridiculously low price at which Overstock’s shares currently trade. The company currently trades at less than four times gross profits. Overstock’s business model makes this an absurd valuation. Why?
Overstock does not take physical possession of more than half the orders it receives. In the long run, this will greatly increase Overstock’s return on capital. The company’s return on capital will benefit further from a negative cash conversion cycle. This model makes gross profits and fulfillment partner revenue particularly valuable.
“Fulfillment partner revenue is generated when we sell the merchandise of other retailers, catalogues or manufacturers through our consumer Website. We do not own or physically handle the merchandise for these transactions unless the product is returned. The entities with which we have a third party fulfillment relationship ship the products directly to the end customer”
Overstock’s Fulfillment partner revenue grew by 65% from $243 million in 2004 to $401 million in 2005. By comparison, direct revenue only grew by 52% from $185 million in 2004 to $282 million in 2005.
The two most important numbers in any Overstock earnings release are gross profits and fulfillment partner revenue. Growth in both of these numbers was stronger than I had anticipated.
Overstock does not face a real risk of insolvency. Despite the substantial negative cash flows for the quarter, I now judge the risk of insolvency to be substantially less than I had earlier suggested. I never believed insolvency to be probable, or even close to probable. I now believe I was wrong to devote any of my analysis to that risk.
The company’s financial position is reasonably strong. It has adequate reserves to cover any unexpected cash outflows. Most importantly, I now realize that I grossly overestimated necessary advertising and technology costs. Although it is good to be conservative, I took a sound principle to an unsound extreme.
It is clear Overstock could already operate as a a cash flow neutral or nearly cash flow neutral business over the full calendar year. The company controls its own destiny.
Insolvency could only occur through gross managerial ineptitude. Management may choose to delay the generation of free cash flow for some time; however, it does not need to. Spending on advertising and technology could theoretically be reduced enough to generate free cash flow over the next twelve months, even if Overstock does not grow sales any faster than its industry.
As of December 31st, 2005, Overstock had $112 million in cash and marketable securities. There is no scenario that does not involve gross managerial incompetence that could lead the company to seek additional financing merely to remain solvent.
I allowed my (justified) belief that financing would be difficult to obtain to cloud my judgment. Overstock has no need for additional financing. The company has sufficient capital on hand to grow the business faster than its industry for several years. Such growth would guarantee free cash flow within only a few years.
Some analysts are predicting Overstock will achieve profitability in 2006. While profitability is likely achievable over the next twelve months, it would require substantial reductions in spending on advertising and technology. I am not convinced management will choose to reduce spending by an amount sufficient to ensure profitability. In fact, I am not convinced such reductions would be in the best interests of long – term shareholders. However, I am now convinced that Overstock faces no real risk of insolvency, and that truly free cash flow generation over the next five years is highly probable.
I am still not going to make any predictions about the short term. I can not state that truly free cash flow generation is probable for any of the next three years. However, taken in the aggregate, the next five years will very likely provide truly free cash flow.
Finally, while I see no point in making yet another grand statement about Overstock’s true value, I am willing to admit that my original $1.5 billion estimate was unduly conservative, and that a $2 billion estimate would have been more appropriate. The company’s enterprise value is still less than $500 million. At this price, Overstock remains one of the most attractive investments available.
Please feel free to provide your thoughts and/or analysis regarding Overstock by leaving your comments below. If you would prefer, you may discuss Overstock with me privately via email.
Read my original Overstock post