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Overstock Is Unbelievable - In a Good Way
Posted by: batbeer2 (IP Logged)
Date: March 19, 2012 10:31AM

Every week, Sam Antar or Gary Weiss will find something amiss with Overstock (OSTK). These two bloggers, combined, must be spending at least 16 hours a week researching and writing about a $125 million stock. According to their disclosures, they have no position.

Since I can’t afford to spend that much time investigating individual trees, I’ll stick to sharing my thoughts on what I perceive to be an extraordinary forest.

A tale of two retailers – part one, the importance of inventory turnover.

The guy selling used cars needs an inventory of, say, 20 cars to sell 1 today. That’s an inventory of $200,000 for $10,000 of revenue. After buying a replacement car to top-up his inventory, paying the rent etc., he takes home $1,000. That’s a 10% margin on an inventory turnover of 5%.

Our guy is married to a baker. She needs an inventory of about $20,000 (flour, yeast, etc.), to sell $10,000 worth of bread today. After buying some new flour and paying for costs, she too takes home $1,000. Her margin too is 10% but the inventory turnover is 50%.

The couple decides it’s time to expand. They need just $1,000 per day to live on. They can invest the other $1,000. The wife tells him she can open an extra bakery within a month without going to the bank for a loan. He just can’t believe it. His dad spent a decade repaying the loan they needed to setup the family business.

Overstock’s numbers are unbelievable


Overstock’s inventory turnover is better than the other retailers combined. Unbelievable! I'll be writing about it in part two of my "tale of two retailers."

Days payable is an indicator of how quickly a company pays its creditors. Overstock is beaten (just) by Costco (COST). Both companies, on average, pay their creditors within a month. In this business it's not unusual to keep your creditors waiting for two months or more. Overstock and Costco are the exceptions.

Assuming Internet retail is a commodity, it stands to reason that Overstock should be able to raise gross margins to about 20% without losing a lot of market share to Amazon, Blue Nile or for that matter, Bluefly. Overstock has untapped pricing power.

So now you know why Francis Chou is long Overstock and why Costco is Charles Munger’s favorite company.

A tale of two retailers - part two, Overstock.

Overstock is a couple (pun intended) of retailers.

Fifteen percent of revenue and roughly 100% of the inventory is carried by the direct business, a “classic” retail operation. They buy stuff (mainly closeout lots) and sell it (hopefully) at a profit.

The other 85% of revenue is from the fulfillment partner division. This is not a classic retailer, this is a broker. Overstock sells merchandise of other retailers, cataloguers or manufacturers ("fulfillment partners") through their website. This is a retailer without inventory! Here too, Overstock deals with closeout lots. The original manufacturer (say, Calvin Klein) doesn’t want last year's watch to compete with this year's model. They won’t be touting it on their own website or in their own shop — that’s where Overstock comes in. Calvin Klein will list last years unsold watches on Overstock.com.

This division is growing at a fair clip. Again, this is a broker. Customers pay for the purchase upfront and Overstock pays the supplier later. This is inherently a negative equity business. The business model is not unlike Dell a decade ago.


Are they going bankrupt?

Summary: No.

  • $100 million of cash on $20 million of debt.

  • Should they choose to extend their “days payable” from the current 30 to a more normal 60 days, at least 1/12 of annual revenue converts into cash on the balance sheet: 1/12 * 1 billion => $85 million.

  • The “direct” business is in decline. Assuming it continues down that road, that inventory, at 0% gross margin, converts into $25 million of cash.

  • Unlike a typical retailer, they don’t need that cash to build seasonal inventory. It’s truly excess cash.

    Why is revenue flat? Why aren't they profitable?

  • As discussed, they don’t need the cash. For now, they are content to invest for growth and kill the competition with low margins. Direct competitors are Bidz.com (toast) and Bluefly (no cash and negative FCF).

  • Sixty percent of revenue is from "home and garden" and 99% of revenue is from U.S.
    Growth is tied to the housing market.


    So what is the company worth to me today ?

    I would pay $ 160 million ($ 7 per share) for the entire company in an instant. I would defer payment of the creditors for an extra month (that would bring it in line with the competition) and use the $ 85m of cash thus generated plus the $ 100m that's already on the balance sheet to pay myself a $ 180 million dividend next month. I would then distribute ownership of the company to the employees and go fishing.

    Prem Watsa says I'm a terrible analyst and a worse LBO artist. He says it's worth more, much more.


    Read more:

    recent 10k
    Sam Antar and Gary Weiss
    Gusto Duel submitted OSTK for the value ideas contest
    Anh Hoang discussed OSTK
    Citron Research covered the space; NOT bearish on Overstock !
    Geoff Gannon on Overstock in 2006



    Disclosure

    This is not a recommendation to buy or sell anything. At the time of writing, I had no position in any of the stocks mentioned. Any and all questions welcome as usual.


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    Re Overstock Is Unbelievable - In a Good Way
    Posted by: ramands123 (IP Logged)
    Date: March 19, 2012 01:10PM


    Some other facts -

    a) Fulfillment business (85 %) has grown YOY continously including last year
    b) Creditor is US Bank which is one of themost conservative lender out there.
    c) CEO with his father owns around 35 % of the equity. Bankcruptcy is the last thing in the world he wants to see.
    d) Fairfax's investment manager sits on Board of directors.
    e) CEO did not take any salary or bonus for last 10 years, reminds me of Richard Handler of Jefferies.
    f) Sells at 0.1 times the sales compared with Amazon which sells at 1.8 times. This implies that Amazon sells at almost 18 times more on basis of sales.
    g) There sales on percentage basis over last 10 years have actually grown faster than Amazon.
    h) CEO is son of the guy who ran Geico and Warren Buffet has very high regards for him.

    My personal assumption is that as they acheive economies of scale thier fixed costs on IT and other areas would become less significant contribute to positive free cash flows and net income. Until then i am hold and long on OSTK


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    Re Overstock Is Unbelievable - In a Good Way
    Posted by: tonysf (IP Logged)
    Date: March 19, 2012 01:20PM

    Well, the key questions are

    Has OSTK been successfully using a low price/low margin strategy in pushing out competitors?

    or

    Are its competitors, some are much bigger with solid financial positions, forcing OSTK to compete with low prices, making OSTK a low margin company?


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    Re Overstock Is Unbelievable - In a Good Way
    Posted by: batbeer2 (IP Logged)
    Date: March 19, 2012 01:26PM

    Hi Ramands123, thanks for your contribution.

    >> d) Fairfax's investment manager sits on Board of directors.

    Who is he ?

    >> h) CEO is son of the guy who ran Geico and Warren Buffet has very high regards for him.

    CEO himself ran a Berkshire subsidiary (Fechheimer) for a while.


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    Re Overstock Is Unbelievable - In a Good Way
    Posted by: batbeer2 (IP Logged)
    Date: March 19, 2012 01:36PM

    Hi Tonysf, that question more or less sums it up.

    I'd say # 2 because:

    1) Higher turnover at equal margin will enable you to beat your competitor (better cashflow).

    2) OSTK has a superior financial position with $ 100m of excess cash. It's not readily apparent because of the payables on the liability side of the balance sheet.

    At $ 1 billion of revenue and a business model where you pay your suppliers after, $ 70m of payables is nothing. They pay their suppliers much quicker than any of the comps (bar Costco).

    Think of it this way: they could pay a $ 150m dividend in May without issuing any debt and no impact to the core business. That's a lot for a $ 125m company.


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    Re Overstock Is Unbelievable - In a Good Way
    Posted by: Adib Motiwala (IP Logged)
    Date: March 19, 2012 01:50PM

    Batbeer,

    I took a few minutes to look at this. Some observations and questions

    1) The Direct business that you say is in liquidation. Had sales of $160m last year at 8% Gross margins. I do see inventory is coming down and contributing to cash flow. So will we see only $22m-$25m in sales from this division and then its done/closed down?

    2) The fulfillment business which is essentially a broker, records the revenues on a gross basis. Their partners actually do most of the work. From 10-k "_ ; however, we handle returns and customer service related to substantially all orders placed through our Website."

    question: Does Amazon also record fulfillment sales on a Gross Basis?

    I am not sure we should use the $890 million in sales from FulFillment segment as their sales and value OSTK on a EV/Sales basis.


    3) Their Op Expenses have been rising especially technology and G/A spending while marketing was flat over last year. As a result, Op Ex of $196million exceeds Gross Profit $179million. And if the retail business is going to wind down , there will be more pressure on the broker business to offset these expenses. Do you know if these expenses will remain flat now as they have increased from $156m to $174m to $196m from 2009 to 2011.

    However, the things to like are the balance sheet in the form of $80million in excess cash (i subtracted the $17m in line of credit that shows up in current liabilities.

    For FCF, I am using
    Net Income + D/A + Decrease in Inventories - Capex

    It was positive in 2009 and 2010 but not so in 2011 using this definition. Ofcourse, if you use all the working capital changes it shows up as positive...(without deeper study I cannot determine whats the right adjustments to use..)

    For now, I am on the sidelines. I want to watch if they can achieve scale with their fulfillment business to more than offset the op ex.



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    Re: Re Overstock Is Unbelievable - In a Good Way
    Posted by: batbeer2 (IP Logged)
    Date: March 19, 2012 02:08PM

    Hi Adib,

    >> So will we see only $22m-$25m in sales from this division and then its done/closed down?

    No. They are slowly running-off that business. They are not simply selling off all the inventory. They're just not taking on as much new inventory as they used to. In time, that inventory will go to 0 and be converted into cash.


    >> Does Amazon also record fulfillment sales on a Gross Basis?

    No idea. I'll get back to you on that.


    >> I am not sure we should use the $890 million in sales from FulFillment segment as their sales and value OSTK on a EV/Sales basis.

    I don't think that would be a good way of valuing OSTK.


    >> Do you know if these expenses will remain flat now as they have increased from $156m to $174m to $196m from 2009 to 2011.

    I don't know and I definitely wouldn't bet on it.


    >> For FCF, I am using
    Net Income + D/A + Decrease in Inventories - Capex


    Capex !? Add up five years of capex and compare that to PP&E. That is not maintenance capex by any stretch of imagination.



    - EDIT -

    Regarding Amazon, from their 10-k:

    Generally, when we are primarily obligated in a transaction, are subject to inventory risk, have latitude in establishing prices and selecting suppliers, or have several but not all of these indicators, revenue is recorded gross.

    We generally record the net amounts as commissions earned if we are not primarily obligated and do not have latitude in establishing prices.

    So, Amazon's revenue is probably a bit understated.


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    Re Overstock Is Unbelievable - In a Good Way
    Posted by: ramands123 (IP Logged)
    Date: March 19, 2012 03:43PM

    HI Bat Beer2,

    #1> He is Mr. Mitchell ( he is a managing director of Hamblin Watsa Investment Counsel which manages investment portfolio of Fairfax. ( Reference Overstock Proxy report 2011)).
    #2 > Yes you are right Patrick did run Berkshire unit for some time.

    Thanks


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    Re Overstock Is Unbelievable - In a Good Way
    Posted by: AlbertaSunwapta (IP Logged)
    Date: March 19, 2012 07:16PM

    Batbeer,

    Hilliarious, are Antar and Weiss really still at it?

    Also, I assume OSTK and TJX should be benefitting from recessionary effects upon retail businesses and their suppliers combined with a recovering market driven by very price conscious shoppers. If you agree, do you think the margins can be maintained?

    Note: I once wrote to OSTK suggesting that they work a deal with SHLD to be their online service, using the Sears stores as bricks and mortar delivery-pickup sites. Seems that they could also have served as Sears/K-Mart's liquidation service. :-)

    Now you've got me thinking that OSTK is a buyout candidate. But by who?

    Batbeer, if you like the 'new' OSTK broker business model, take a look at PointsInternational (Points.com). I'd love to hear your thoughts.


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    Re Overstock Is Unbelievable - In a Good Way
    Posted by: batbeer2 (IP Logged)
    Date: March 20, 2012 12:44AM

    Hi AlbertaSunwapta,

    >> If you agree, do you think the margins can be maintained?

    I think OSTK will be keeping their margins lower than the others for years to come. I know that wasn't exactly your question.


    >> Note: I once wrote to OSTK suggesting that they work a deal with SHLD to be their online service, using the Sears stores as bricks and mortar delivery-pickup sites.

    That thought did cross my mind. It would answer your other question.

    I'll take a peek at points.com, thanks.


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