Overstock.com (OSTK): Part Four – Earnings Based Valuation Exercise

Let’s start at the end. Let’s run through an exercise to see if Overstock’s business is worthy of a valuation high enough to even consider an investment.

Because Overstock is not a blue chip company with the most durable competitive advantages protecting its earnings, I want a minimum doubling of my investment to make the opportunity worth the risk. At roughly $14/share at the time of this writing, that means I must find a clear and conservative path to $28 within the next few years if I’m to part ways with my hard-earned cash.

EPS Multiple

I’ll use net earnings and just try a 15x multiple. Why? It’s well below Overstock’s current 24x and WAY below Amazon’s 70x+. My gut tells me that a growing internet-based retailer with high-ROIC  and earnings growth will find a much more sympathetic Mr. Market than 15x, but I only want to build the model off conservative assumptions. If they don’t work, we’ll take a pass. (Conversely, if we don’t see a reasonable path to growing earnings, we’ll assume the company isn’t worth anything and move on.)

Assuming a steady share count around 24 million, this means Overstock would need to produce $45 million in net earnings, $31 million above its previous high mark last year. ($1.88 earnings per share * 15 multiple = $28.20.)

OSTK Earnings—Take One

It’s tempting to drop straight to the bottom line of Overstock’s financial statement and wince at the 1.3% profit it posted for 2010. $14 million of earnings on almost $1.1 billion in revenue? That doesn’t blow anyone away.

How would that get us to $45 million in earnings? Assuming everything scales proportionally to 2010, revenue would have to grow to $3.5 billion. Forget driving a truck through it… a wild-eyed optimist couldn’t squeeze a pancake through that.   

But as discussed previously, profit margin is not the story of this company. Running a nearly frictionless business where minute amounts of invested capital produces $880 million in fulfillment partner revenue with nearly 20% gross margins plus a slowing expense structure…that’s where the story starts. Let’s go in a little deeper.

Gross Profit & Expense Structure

Does the business produce a defensible gross profit? I like consistency here. It speaks to pricing power (or at least the avoidance of damaging price wars) and the stability of input costs (raw material or, in the case of retailers, merchandise). But most importantly, a consistent gross margin creates a predictable bucket of dollars upon which a company can build its expense structure.

Fluctuating gross margins, on the other hand, make it almost impossible to create rational expenses needed to support the business. Management has to scale expenses to invest in the business when margins are high, only to rein them in hard when margins decline. Earnings bob around as a result, and it makes it very hard to get operations hitting on all cylinders (i.e., you’ll see a lot of restructuring and turnaround initiatives in companies that don’t have dependable gross margins).

I want to see that a company produces enough gross margin to comfortably cover its nut (fixed operating expenses) and have plenty left over for its variable operating expenses. We look at the former first because it’s hard to reduce fixed costs very quickly. In case of the latter, variable costs can usually be cut if you need to pare back.

I go so far as saying that I don’t necessarily care what a company’s gross margin percent is. I want to see the dollar amount covering the expenses. After expenses are paid for, I’m all for selling more product or service at any gross margin percent as long as that doesn’t hurt the franchise, the business’s long-term prospects, or increase expenses. Why? After your expenses are paid for, each additional $1 of gross profit drops straight to the earnings box regardless of whether you sold it at 20% or 1% margin.  Percentages be damned! That’s cold, hard cash.

     

Some businesses will need 70% margin to cover expenses; others maybe only 15%. It depends on the industry, the business model, and the unique needs of the company. As Michael Porter has shown in various studies, the ability to function on a low gross margin can give you a powerful competitive advantage in the form of lowest price (especially when you reach scale and your competitors cannot follow). The $420 billion flowing through Wal-Mart’s bank accounts each year is pretty convincing evidence of taking the concept to the nth degree.

OSTK Earnings – Takes Two Through Four

Now let’s reconsider Overstock’s earnings in light of its gross margin and operating expense structure to see whether we reach an earnings number upon which we can base a decent valuation.

In 2010, Overstock generated a $167 million gross profit from its fulfillment partner business alone. Its total expenses were about $175 million. That leaves an $8 million gap for the company to hit breakeven if fulfillment were a standalone business. As we know, Overstock also sells its own inventory. That piece of business created about $22 million in gross profits and pushed overall net earnings into positive territory near $15 million.

So we don’t value this company based on growing revenues and using the same net profit (1.3%) to find a path to $45 million in earnings. We value it based on keeping expenses in check while growing revenues at a high enough rate to carry more dollars through the gross margins.

From 2008 (when it’s clear that Overstock has made the full transition to the fulfillment partner model and its reduced capital requirements) through 2010, the business went from $10 million loss to $15 million gain. Revenue grew from $834 to $1,090 million (31% increase), and gross profit went from $143 to $190 million (33% increase, but staying nearly flat as a margin at about 17% of overall sales). Expenses grew from $154 to $175 million (14% increase). 

If we play with those variables to create a variety of growth scenarios, we can generate the following possibilities for Overstock’s compounded growth for the next two years:

Scenario One:  We assume the business compounds for the two years 2011 through 2012 at the same pace it grew in 2010. (Gross margin is the average of 2008 through 2010 for each scenario.)

	Annual Growth Rate	New Revenue #	Gross Margin	Results
Fulfill. Business	21%	$1.29B	19%	$245M
Direct Business	39%	$405M	12%	$49M
Total Expenses	11%			($215M)
EARNINGS				$79M

Divided by 24 million shares, that is $3.29 EPS. At 15x, that creates a value of $49.38 per share. That’s a 250% premium to Overstock’s current trading price.

Admittedly, it’s also pretty rosy to take the results of the company’s best ever year for earnings and assume the future will look the same. Let’s try tamping it down a little…

Scenario Two: Here we assume that the business will compound at the two year averages of 2008 through 2010.

	Annual Growth Rate	New Revenue #	Gross Margin	Results
Fulfill. Business	16%	$1.18B	19%	$225M
Direct Business	13%	$268M	12%	$32M
Total Expenses	7%			($200M)
EARNINGS				$57M

Divided by 24 million shares, that is $2.38 EPS. At 15x, that creates a value of $35.70 per share. That’s a 155% premium to Overstock’s current trading price.

And here’s one more look…

Scenario Three:  This is a repeat of the 2008 to 2009 growth rates compounding for 2011 and 2012.

	Annual Growth Rate	New Revenue #	Gross Margin	Results
Fulfill. Business	10%	$1.07B	19%	$202M
Direct Business	-13%	$159M	12%	$19M
Total Expenses	2%			($181M)
EARNINGS				$40M

This creates to most conservative growth rates for the business lines (even shrinking the direct business rather dramatically). Of course, management did an excellent job that year holding expenses in check.

Divided by 24 million shares, that is $1.67 EPS. At 15x, that creates a value of $25.05 per share. That’s a 79% premium to Overstock’s current trading price.

Even at the worst of the two year performance scenarios, Overstock looks pretty enticing. It’s not quite the $45M earnings we said we needed, but if this is truly conservative thinking I wouldn’t disregard the opportunity.

So, we’ve thumbnailed some rough valuations by making a stab at normalizing earnings. Next, we need to consider what sort of competitive advantages Overstock has in place to give us confidence in these projections.