Overstock.com (OSTK): Part Three – Business Synopsis

Finally, back to Overstock.com…

Overstock charged out of its IPO gate by stringing together three years of 100%+ revenue growth. It went from $40 million in revenue in 2001 to nearly $500 million in 2004. It was plowing every penny back into growth, issuing additional shares and taking on debt to fund inventory expansion, warehouse space, marketing spend, additional personnel, etc.

These were heady times.

Management’s stated goal was to operate right at the break-even point, but they were ambitious and when decisions about growth faced off against decisions of tighter expense management, growth won.

The company went on a technology investment tear in 2005, adding over $70 million to overhead expense on software, IT projects, and supporting personnel. They were building the infrastructure, CEO Patrick Byrne said, to support a $2 billion business.

At that point, Overstock was nearer to the traditional model of retailing than it is today:  it bought goods, put them in warehouse inventory, and shipped them out as they sold.  More demand from shoppers meant plowing back more cash into working capital (to buy the inventory and pay for the personnel to manage it) and into capital expenditures (expanding warehouses and IT systems).

Total invested capital at the end of 2005 was $164 million. Most of that sat in inventory; much of the remainder was fixed assets like an expanded warehouse to house the growing inventory.

Then the growth just stopped. 2005 still looked good with 63% higher sales, but they were expecting to be closer to a billion. Losses started mounting. The technology projects were implementation disasters, hitting in the worst time possible for a retailer…holiday buying season. They couldn’t handle the transaction levels and they couldn’t replenish their warehouses and get stock back up on the website.

On that $164 million of invested capital, Overstock produced a net loss of about $25 million. ROIC? Negative 15 percent.  But even if they managed to produce a $14M profit as in fiscal year 2010, on that capital base the ROIC would still be a paltry 8.5% (acceptable for some industries, but not this one).

More to the point, they burned through over $50 million in cash and things weren’t looking good going into 2006 where revenue would shrink for the first time and gross margins would drop as they tried to get rid of bad inventory from 2005 (i.e., they had to sell it cheap to get people to buy the stock in the warehouse).

The survival of the business was at stake, and Overstock went into overdrive to revamp its business model. It did all the traditional dirty work to cut expenses, but the real transition came from reconfiguring its relationships with suppliers. Rather than acquiring inventory from them, paying them on 30 day terms, selling the goods in about 60 days, and financing the difference with its own cash, Overstock asked them to become fulfillment partners.

What does that mean? These partners would continue selling through Overstock, but they would retain the inventory (and the costs/risks of owning it) until a purchase was made. Overstock would get the credit card payment, the partner would ship the product to the buyer in a nice-looking red “O” box, Overstock would handle any customer service issues, and then Overstock would issue a payment to the partner minus a “commission.” Fulfillment grew to become over 80% of company revenue.

Overstock now gets a payment from customers before it has to pay its suppliers. Inventory dropped from a peak of $100 million at the end of 2005 to a 2010 average of less than $30 million. It has produced two consecutive years of net income. It has built over $100 million of cash reserves. It has very little debt.

Patrick Byrne, the CEO, makes strong suggestions in earnings calls that Overstock’s market value is disconnected from his view of its intrinsic value. He is bullish about the company and, since bringing it to profitability, has begun increasing the expense structure to invest in what he calls Overstock’s “innovation cycle.”

There is little question that the change in capital investment needs has been impressive. No doubt, the Overstock management has done a remarkable job bringing the company back from teetering on the edge. Should we share his enthusiasm? Does Overstock.com represent a strong value investment opportunity?