Overstock's Turn

In keeping with this trend of using the Warren Buffett Way to evaluate all my investments, in this post I'll look at Overstock.

Business

Simple and Understandable

Overstock sells the overstocked goods from other companies on its website. Part of its revenue comes from inventory Overstock buys from companies, the rest comes from 'partner' revenue where companies sell their inventory on Overstock's site and Overstock gets a commission.

Consistent History

Not even close. After Overstock started it had extreme revenue growth for a few years, then Byrne got distracted and the company went to hell with negative revenue growth, currently it has come to kind of a stand still while the company attempts to turn-around.

I believe that when Overstock become profitable earnings growth will be huge for a few years then it will grow consistently over time.

Long-Term Prospects

There is a lot of uncertainty here which is a big part of why the stock price is so depressed.

I believe the company has good prospects and has already started a great turn-around. Profitability will serve as a catalyst for Overstock's business and share price in the future.

Revenue growth looks like it has dimmed over the past few years, but as the company fazes out the direct portion the total growth will fall to pave the way for the much higher returning partner revenue, which has grown 20% in the last two years - most of that coming over the last year when Byrne really got his head back in the game.

Management

Rational

This one could be looked at as so-so.

Byrne has a lot of expectations and a lot of lofty goals in turning-around the company, but so far I believe he has done well meeting his expectations and communicating the progress to shareholders.

Candid

Byrne could be called the best CEO for a shareholder because of his fight, against hedge funds that drove down the stock price, but I believe the best CEO is the one who runs a very profitable business and returns the cash to shareholders.

Since, Overstock has yet to be GAAP profitable he hasn't been able to do this, but I do believe he is extremely candid detailing his turn-around plans to shareholders and teaching how his metrics for evaluating the company should be used.

Resists Institutional Imperative

If there is a CEO who resists the institutional imperative the most it is Patrick Byrne, he could not care less about what any analysts care about him and has routinely let them know.

Financials

Return on Equity

Overstock is not yet profitable, but because of its great partner business (which has a working capital model like Dell or Costco where it receives the cash for sold products within a week, but doesn't have to pay the company for a month) just a 1% profit margin would bring a 28% Return on Equity were they to achieve the margin of Amazon (very likely in a few years) of 3.2% it would have a return on equity of 90% (its likely by this point the company would have had to invest more money into the business and there would be more equity, revenue growth may or may not keep up with the capital growth).

Owner's Earnings

Overstock does not have positive Owner's Earnings, but it the trailing twelve months it produced $10 million in operating cash flow, while paying $2.6 million in capital expenditures this is free cash flow of $7.4 million.

Profit Margin

Overstock's profit margin is currently negative 6%. The company currently has a 17% gross margin which is low, but has been increasing and the new focus is on trimming down costs. This margin should reach 20-23% .

The company also paid 15% of revenue on technology and marketing expense - variable costs that will fall as the revenue increases.

Valuation

This can be called a crap shoot with Overstock. It's very easy to say they are since they trade for 2/5ths of sales.

But, since the occurrence of profitability is unknown pinning an exact value on Overstock is very difficult.

In an attempt to remain simple I have valued it in two ways:

• If Overstock can grow revenue 15% over the next two years, and achieve 2% profitability it would have $17.5 million in earnings, a 20x multiple on this is $350 million, add net cash of about $25 million and you have a market cap of $375 million, this is a 44% increase or 18% per year. I believe the 20x multiple is conservative because at this point the company will have ~56% return on equity, will have killed Wall St. doubts of its profitability and will have the benefit of millions of shares currently sold short being bought back.
• Secondly, I believe a sophisticated businessman or company would easily pay 1x sales for Overstock, because of its wide moat in the online liquidation business and the potential for a high return on capital, this equates into a $760 million dollar market cap which is a 192% return.

Conclusion

In conclusion, Overstock is a classic Mohinsh Pabrai investment, the company is low risk - it has great relationships with partners and a big moat keeping its customers and is well on the way to achieving profitability as proven by it positive free cash flow, plus the stock priced is depressed to the point that it's trading for less than half of sales - but has high uncertainty - Wall St. thinks it will never become profitable.