Geoff Gannon November 8, 2006

On Overstock’s Terrible Third Quarter

I did not expect to learn anything significant about (OSTK) until the fourth quarter results were in, because the Christmas season is so critical to the company’s success. However, Monday’s announcement of a year-over-year decline in revenue was completely unexpected.

Based on Byrne’s remarks and the reported results, it looks like Overstock got everything right except conversions. I was pleasantly surprised with how well the company managed its IT systems and its inventory. In the past, management had made mistakes in these areas and Overstock paid the price. This quarter they did a great job on both fronts.

Unfortunately, the fantastic growth that had allowed Overstock to move forward despite serious missteps (in previous quarters), was totally absent this quarter.

In his letter to owners, Byrne wrote:

“In the past we ran at an A- and regularly generated 100% growth: now I think we are running at an A+ but seeing no growth. I am not entirely sure what to make of that.”

I agree. That’s the real story. The company gave its best performance – and posted its worst results. The CEO can’t explain it and I can’t either.

At the beginning of this year, I thought Overstock could grow sales at 10-15% for the year. I expected to see total sales for 2006 of between $875 million – $925 million. In the first three quarters of 2006, the company only generated about $500 million in sales. So, Overstock would need $375 million to $425 million in sales during Q4 to get to where I expected them to be at the end of the year. To put that in perspective, the company had sales of $318 million in Q4 of ’05.

So, Overstock would need to post year-over-year growth of 18 – 34% during the fourth quarter of this year just to reach a target I thought was sufficiently conservative when I set it about a year ago.

Then, there’s the issue of cash. Like I said, Overstock did everything right this quarter and still posted very poor results.

In February, I wrote that “Insolvency could only occur through gross managerial ineptitude”. Clearly, I was wrong. Overstock’s management is not inept; in fact, they’ve made meaningful improvements to the business in the first nine months of 2006. Overstock is a much more efficient operation today than it was a year ago.

However, there is a real risk of insolvency. If Overstock’s fourth quarter results don’t show year over year growth of at least 15-20%, it seems nearly certain they will have to raise cash in 2007.

Even if the fourth quarter looks great, there may be a need to raise cash. If the company has to raise cash while its prospects appear terribly dim, the terms on which the cash is raised are likely to be extremely detrimental to current shareholders.

Overstock has a solid business model. Unfortunately, the logic of that model is predicated upon sales volume growth. The business simply can’t operate profitability on such a small volume. If Overstock can’t grow sales, it can’t survive.

If we see really poor sales growth in the fourth quarter, despite Overstock’s excellent name recognition, I would have to question the firm’s viability. If the company reports year-over-year growth in the single digits for Q4, I’d have to seriously question whether this is a viable business.

The third quarter results (themselves) are unimportant. But, the fact that revenue declined going into the critically important fourth quarter is both surprising and unsettling. I never imagined a quarter could be this bad. Clearly, I don’t understand the business, because I really did believe a year-over-year decline in sales was unthinkable. These results shake the foundations of my case for Overstock.

Now, the natural question is whether the stock is (in my opinion) a buy, sell, or hold. That’s not the way I usually discuss stocks on this blog – and it’s certainly not the way I’m going to discuss this stock. I’ve already demonstrated I don’t understand the business; if I did, I would have been able to see that Overstock could experience a year-over-year decline in revenue despite strong brand recognition. I didn’t recognize that possibility; so, clearly I don’t understand the business.

Having said that, I am aware of the dangers of announcing my lack of confidence in Overstock (and thereby reversing my earlier pronouncements) at precisely the time the stock is making new lows. On the basis of price-to-sales this remains a very cheap stock, if the company’s growth prospects are reasonably good.

Based on the site’s traffic and customer awareness, I was convinced Overstock’s growth prospects were good enough to justify purchasing the stock. Now, I’m not sure, because any failure to grow sales will result in insolvency. I thought the likelihood of such a failure was extremely low; now, it looks like a real possibility.

It’s clear I don’t understand this business. So, personally, I’m unwilling to own it. I can’t assess the risks of owning shares in If I can’t assess the risks, I can’t own the stock – it’s that simple.

However, I can’t, in good conscience, encourage others to sell at levels that present the possibility of great rewards if Overstock achieves merely mediocre business results.

Furthermore, I had no intention of writing about this stock until the fourth quarter results were in, because I believed those results would be the only ones I could learn anything meaningful from. I still believe the fourth quarter results will be the most important piece of information we receive. But, that would mean a long wait.

There is certainly no assurance that Overstock’s share price will decline. In fact, being short the stock (today) presents greater risks than being long the stock.

If some evil omnipotent were to force me to choose between being short the stock by x dollars or being long the stock by x dollars, I would certainly choose the latter. It’s a lot easier to sleep when your liability is limited. A short stake creates an unlimited liability (in dollar terms). So, where a huge price movement in some direction is almost certain (as it is in the case of Overstock), it’s safer to take the long side. Here, my point has nothing to do with short-term price movements. It has to do with Overstock’s precarious position.

Overstock will either survive or it will fail. If it survives, it would be nearly impossible for the stock to trade much below this level. In fact, if the business survives, the stock price will very likely have to rise by several hundred percent in any market. Obviously, if the business fails, the stock will be worthless.

Is Overstock a good bet? I don’t know. Is it a safe bet? No.

Related Reading (OSTK)

An Analysis of Overstock (OSTK)

On the Rationale for the Overstock Post

On Overstock’s Fourth Quarter