Overstock.com

Business Description (From 10k)

"We are an online “closeout” retailer offering discount brand name merchandise, including bed-and-bath goods, home décor, kitchenware, watches, jewelry, electronics and computers, sporting goods, apparel, designer accessories and limited travel services, among other products. We also sell books, magazines, CD’s, DVD’s, videocassettes and video games (“BMV”), and we operate as part of our Website an online auction site—a marketplace for the buying and selling of goods—between our customers. Therefore our Website is comprised of five main tabs: Shopping; Books, Music, Movies and Games; Bulk Buys & Business Supplies; Auctions; and Travel.

Business Model

Overstock's business model is pretty genius if you look at it. Usually liquidators don't work very well for a variety of reasons including retailers not wanting to be close to a store that sells its products at liquidation prices - this doesn't happen with Overstock because it is online - and though the liquidators can buy products at liquidation prices and sell them for lower then wholesale they usually have a volatile selection and may not have what you're looking for - this doesn’t effect Overstock either because it has relationships with many retailers and warehouses stocked full of product waiting to be sold. See the Overstock solution here for more advantages.

40% of revenue comes from direct business, which means Overstock takes direct possession of the inventory in one of it's warehouses located in Utah and Indiana and ships to the customer directly from those warehouses.

The 60% comes from fulfillment partner revenue. Currently Overstock has relationship with about 460 retailers who sell their overstocked product on the website. Overstock never physically handles the inventory of these transactions it also receives the payment of the transaction in less then a week while it doesn't have to take out its commissions and pay the retailers for one month. This Cash Conversion Cycle is what powers company such as Dell and Costco it will fuel high Returns on Capital for Overstock when it becomes profitable.

Currently Overstock is pursuing a business model hat has proven highly successful in the internet business - see Amazon.com and Netflix - Overstock spends a lot of money building its brand name with technology and marketing expenses, during this period it is unprofitable. Because of the tremendous spending revenue grows extremely fast - from $90milion in 1999 to almost $900million today. As revenue slows down it leverages its variable - marketing and technology - costs and revenue grows faster then them to create an operating profit. This method has been doubted by the smartest Wall St. analysts before but it proved effective as Amazon.com and Netflix both went over 500% in the subsequent few years after becoming profitable.

Dr. Patrick Byrne

Even Byrne-haters have to admit that he is at the very least extremely interesting. His father, Jack Byrne, was the long time CEO of GEICO and reportedly Byrne learned to invest directly from Warren Buffett. Buffett also chose him to be the CEO of Fechheimer Brothers, a Berkshire Hathaway company that made security uniforms.

Byrne also has a Black Belt, is a cancer survivor, has ridden his bike across country numerous times, reportedly has a photographic memory and has a PHD from Stanford.

Overall I believe Byrne is a great CEO, focused on the business and working for the shareholders.

Controversial Stuff

There are two major, separate, problems that the CEO is combating. They are too often confused and too often put together. The simple fact is Patrick Byrne is not fighting investors who short his stock he is fighting people who conspired to write hatchet jobs about his company while shorting the stock and fighting illegal naked shorters who have depressed the stock price.

Traditionally shorting involves borrowing stock from one person then selling it on the open market, the shorter eventually uses the procedes from selling the borrowed shares to buy back the stock and return it to the lender. With naked shorts the shorter sells shares he never borrowed nor intended to borrow, this dilutes the amount of shares trading and depresses the company’s stock price. With Overstock there are twice as many shares trading as were issued because of counterfeit shares from naked shorters.

I don’t have enough space to delve far enough into these subjects here, but I would recommend the following two links for those who are interested.

Look at FTDs

CC Transcript

Valuation

Whether or not you believe Patrick Byrne is a good CEO or Overstock is a good company it is undoubtedly undervalued. Amazon never traded for less than 1x sales - even when Wall St hated Jeff Bezos - Overstock trades for half of sales.

All of the Sales multiple valuations I have done are mouth watering. Even to assume Overstock would trade for 1x Sales within a year it is a double, and possibly more assuming revenue growth.

There are a few variations with different multiples and different ending market caps. I do not subscribe to the ‘target price’ valuation techniques and will post earnings based valuations in a later post.

Amazon – Currently Amazon trades for 1.8x Sales, give or take a tenth depending on the current price. This multiple could be low also because Amazon has fallen in the preceding months to this article and is down well from its high. If we discount the 1.8 because Overstock is not profitable and assume to trade equally to Amazon it would trade between 1.2 and 1.5x Sales its proper market cap should be between, $990 million and $1.2 billion, currently the market cap sits at $445 million.

Industry – According to Morningstar the average P/S for Overstock’s industry is 11.8, trading for this would yield a valuation 24x the current price so we will skip it to be conservative.

Future – Currently the online liquidation industry has annual revenues totaling about $60 billion. If we assume Overstock can grab 5% market share in the industry by 2010 and will then trade for 1x sales we can assume a target market cap in 2010 of $3 billion about 6x the current price.

Catalysts

All of the valuation methods listed gave valuations more than 200% above the current market quoted price, but what will cause the stock price to shoot up to that price? Here are some catalysts I believe will or could happen to push up the stock price:

Overstock Becoming Profitable – Right now a lot of doubt considering Overstock’s future prospects in priced into the stock if the company can prove if self and produce an annual profit the stock price will respond. As before mentioned Amazon and Netflix went up 700% in a few years after becoming profitable.

Win Lawsuit – If/When Overstock wins the lawsuit against Rocker Partners and Gradient Analytics the market would probably respond to believe profitability was the company’s main focus.

Byrne has stated before in interviews he has explored the idea of taking the company private. I doubt he will pay $3billion with the company priced at $500million but I do believe he will have shareholders in mind if he decides to take it private.

Risks

The stock price is very volatile. In the month I’ve owned I’ve been down 10% and up 20% within weeks. Value investor do not focus on the stock price instead the intrinsic value, one would do well taking advantage of the volatility instead of fretting over it.

Byrne spends time fighting naked shorters – time that could be spent on improving the business. Byrne has admitted too much of this happened last year but says he has drastically reduced the amount of time not spent on the business.

Overstock’s business model could be flawed to where they may never make a profit, at least not in the near future. I do not believe this, but it is the argument of most OSTK haters.

Conclusion

My conclusion is obviously positive and I have put my money where my mouth is. As of September 15 Overstock represents about 18% of my portfolio, after a 18.9% gain since my first buy at $16.82 per share.

At the time of this Article the author owned share of Overstock, though this could change at any time. This article in no way represents a recommendation to buy or sell any stocks consult your investment advisor before making any decisions.