Wednesday, May 11, 2011 (OSTK): Part Two – Returns on Invested Capital

More than 80% of Overstock revenue comes at no cost to the company.

How’s that for grabbing your attention?

Here’s how it works: Overstock has roughly 1,600 suppliers of surplus, outdated, or returned merchandise that engage the company as fulfillment partners. In exchange for featuring their products on, the suppliers agree to own and manage the inventory and ship orders to customers using boxes stamped with Overstock’s logo.

Overstock runs the website, promotes the site and brand, provides customer support, and processes the credit card transactions. For those services, the company charges its fulfillment partners a 20%-plus commission (give or take).

After a sale is consummated, Amex or Visa puts dollars into Overstock’s bank account. Overstock hangs onto that money for a week or two before paying the suppliers their take. The difference is essentially no-cost money. Overstock never had to buy this inventory, keeping those dollars free for other purposes. It never had to store these products in a warehouse or increase space to carry more merchandise during holiday season. Again, freeing capital dollars for other purposes. It never took on risk that the products might not sell quickly, have to be marked down, and hurt margins.

Overstock augments the fulfillment partner business with about $28 million in owned inventory. Management says this is to fill gaps in the overall variety of products they offer, helping bring traffic to the site.

In 2010, Overstock did $880 million in revenue with fulfillment partners. That produced a frictionless $167 million in gross margin dollars. Those dollars covered all but about $8 million of Overstock’s total expense structure. Overstock’s direct sales made up the difference plus enough to give the company earnings around $14 million.

This was accomplished on less than $30 million of invested capital.  That’s a ROIC rate of 48% given that Overstock had very little tax to pay (the upside of the preceding 10 years of losses). And here’s the kicker: if it can grow the fulfillment side of its business (and that’s not a foregone conclusion…we’ll tackle the competitive pressures and risks in future installments), Overstock will need very little additional capital to do so. 
You don’t have to pull out your HP 12c calculator to see that the numbers could get high very quickly.

Let’s step away from Overstock for a moment and play with some investing theory. Next installment: what’s the big deal about ROIC anyway? 

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