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Overstock: Interesting Turnaround Story with Warren Buffett CEO, Leading to Francis Chou and Prem Watsa Buy

January 10, 2012 | About:
It would be a great signal to see one of our gurus begin to accumulate a significant amount of one stock, on the way down, to own a significant stake in the company. Recently, this was the case with Seth Klarman and Targacept (TRGT). And now it is Francis Chou with consistent buying into Overstock (OSTK).

Since the third quarter of 2011, Francis Chou began to purchase large amount of OSTK when the price was as high as $9.50 per share, and he was buying on the way down. Now he owns more than 2.3 million shares of the company, and OSTK has made up nearly 5.6% of its total holdings. Beside Francis Chou, Prem Watsa is another large shareholder, owning nearly 3.4 million shares, taking more than 14.5% of the total shares outstanding, and the stake in OSTK represents 1.53% of the total fund value of Prem Watsa.

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The stock was at $17 per share at the beginning of the year. Then, it kept dropping and now it is staying at $7.2 per share. So should we follow Francis Chou and Prem Watsa in buying in OSTK when the price is experiencing a downtrend?

OSTK, founded in 1997, in Salt Lake City, Utah, is the online retailer offering discount brand-name, non-brand name and closeout merchandise, including bed-and-bath goods, home décor, kitchenware, furniture, watches and even best-seller books, magazines, CDs, DVDs and video games (BMMG). It has organized the shopping business into two principal segments: a “direct” business and a “fulfillment partner” business. Currently, it offers around 197,000 non-BMMG products in 19 major departments, and around 763,000 BMMG products.

The sales are generated mainly inside the U.S.; less than 1% are made indirectly to international customers. During the past three years, no single customer accounted for more than 1% of OSTK total revenue. The diversification of the customers would make the business less risky and make the investors feel more comfortable in investing in it. In terms of manufacturers, suppliers and distributors, the company hasn’t entered into contracts with manufacturers or other suppliers to guarantee the availability of merchandise for a set duration; it is mainly based on historical experience with manufacturers and suppliers and does not obligate or entitle OSTK to receive merchandise.

The main revenue contribution belonged to the Home and Garden segment, including home décor, bedding, bath, furniture, house wares, garden, patio, etc., making up more than 50% of total sales. Second was jewelry, watches, clothing and accessories, making up around 25%. The rest was BMMG and other segments. As any retailer, OSTK's sales vary due to the seasonality. Historically, higher sales volume occurs during the fourth quarter ended December 31. Around 30-36% of total sales were recognized for the last three reporting years.

In terms of historical operating performance, the business experienced losses consistently although the revenue has been on a rising trend. The operating income and net income just turned positive in two years. The cash flow situation seems to be slightly better, fluctuating widely and beginning to turn positive consistently since 2007. However, because of the high capital expenditure comparing to the operating cash flow, the free cash flow has had ups and downs in the 10-year history.

USD million 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
Revenue 40 92 239 495 804 788 760 834 877 1,090
Operating Income -14 -4 -12 -5 -24 -94 -42 -11 8 15
Net Income -14 -5 -12 -5 -25 -102 -45 -13 8 14
Operating Cash Flow -10 2 -10 25 -6 -26 10 2 46 16
Cap Spending -2 -2 -7 -9 -45 -23 -3 -19 -7 -21
Free Cash Flow -12 1 -17 16 -51 -49 7 -17 39 -4


So the net margin has been staying below zero for around eight years, which would automatically translate into a negative return on equity. The only good thing about OSTK’s operation is the asset turnover number. Over the years, it showed that the asset turnover has been increasing at a rapid and steady rate, from 1.5 in 2001 to more than 5 in 2010 already. Secondly, not many investors might notice, when the sales revenue increased from $40 million to more than $1 billion within 10 years, the total capital expenditure for 10 years is very little. So the increase of $960 million in sales in 10 years resulted from $138 million in total capital expenditure in the same period.

In terms of financial health, the D/A is very high, at nearly 90%; however, the main items fall into the accounts payable, accrued liabilities and deferred revenues. The debt takes only 10% of the total asset, at $17 million. The balance sheet of OSTK is very liquid, with the amount of cash up to nearly $80 million, making up more than 50% of the total assets. Any investors would feel good when looking at OSTK's balance sheet. Now, with the market capitalization of $165 million, adjusting the cash and debt, the enterprise value of OSTK is $102 million only. So by paying $102 million, the investors can get the business generating $14 million net income recently and $16 operating cash flows.

It seems not very cheap, in both earning power and the asset value calculation. However, the closer I look into OSTK, the more I find it interesting. In the 14 filing, it shows clearly that there is very high insider ownership in OSTK, especially the guy named Patrick Byrne, the chairman and CEO of OSTK, who owns more than 29% of the company. In addition, CEO’s father, John J. Byrne, owns more than 5% of the total outstanding shares as well. Altogether, directors and executive officers as a group, collectively own nearly 36%.

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The buy of Francis Chou and Prem Watsa might be due to good management with heavy ownership. Patrick Byrne is the son of John Byrne, the former chairman of GEICO insurance subsidiary and White Moutains Insurance Group and Fireman’s Fund. John Byrne was the guy who turned around GEICO, which then attracted the attention of Warren Buffett. Buffett has called John the “Babe Ruth of Insurance.” The son Patrick was once asked by Buffett to come and work in 1997, running a group of apparel manufacturing companies. Patrick received no salary, and only restricted stock awards as compensation in 2010. So that was remarkable in a sense.

When he got asked how he transformed the bankrupt company at that time, D2: Discount Direct, and transformed it into Overstock, he said: “That company was in the flea market industry. The day we acquired D2 it went bankrupt. Everyone was being laid off, so we stepped in, bought a majority of stake and said “Let’s take a infrastructure and build and transactional website.”

He mentioned about a part of retail called “jobbing.” There would be a canceled order here, or a trick missed a delivery there — things like that happen and goods become available very inexpensively. These jobbers operate in that market, and many products get into the flea market industry. So the idea was to take apparatus for jobbing and build the transaction website that posted all of the products in the Internet.

So it seems like OSTK has very good management, good, candid and an experienced chairman and CEO who knows what he is doing. I believe Prem Watsa and Francis Chou bought into OSTK largely because of Patrick Byrne, and they intend to hold it for the very long term (talking about 10 years).

In terms of the business, the revenue experienced remarkable growth, and the bottom line and cash flow level has turned positive since the last two years. It seems like the fundamentals are shaping up in OSTK. With the current valuation of P/B 10.3x, P/CF 5.3x comparing with the three-year average P/CF of 12.1x, OSTK can be a decent buy at this price. However, I would not think it would be low-hanging fruit; the investors should be extremely patient to hold the company for the long run in order to reap the benefits, and as usual, no matter how good the management is, the future is always uncertain and the managers cannot swim against the headwinds if there are any.

A lot of people talked about the company's frequent earnings restatement, and it concerns investors. Please read further in my post on it.

This is the subjective viewpoint of the author, and it is not the recommendation to buy, hold or sell the stocks mentioned in this analysis. Anyone who wishes to buy, hold or sell the stocks has to do his/her own analysis at his/her own risk

About the author:

Anh Hoang
Money manager into global equities, especially with US and Vietnam markets. CFA level 3 candidate. Lecturer for Stalla - CFA course in Vietnam

Visit Anh Hoang's Website


Rating: 3.6/5 (22 votes)

Voters:

Comments

Hester1
Hester1 - 2 years ago
"So it seems like OSTK has very good management."

Overstock has had more years where they have had to go back and restate earnings than years where they didn't.
ramands123
Ramands123 - 2 years ago


Anh, Can you please explain the business model in more detail ?

What is "a “direct” business and a “fulfillment partner” business" ?

How is overstock different then most retailers ? There has to be something setting them apart for Prem Watsa and Francis Chou to get excited other than managment?
ken_hoang
Ken_hoang - 2 years ago
The direct business is to sell to individual consumers and businesses. And for fulfillment partner segment, it sells merchandises to other retailers, cataloguers or manufacturers through company’s website. Nevertheless, it does not have any legal partnerships with the partners. In other words, you can consider one segment is like retailing, and other is like wholesaling. And it was all done via its website. OSTK has no physical stores available. The business model is typical to post products in flea market in the Internet and sell it via its Website.

The business got stumbled in 2007-2008 period when it installed the ERP system. And thanks for the remind, OSTK has to restated the earnings over and over again. Let me look closer to their earning restatement. There would be a chance that Watsa and Chou buys in to influence the company, and to restructure it to profitability.

aintpopularbut
Aintpopularbut - 2 years ago
Nice inclusion of "Warren Buffett" in the headline. Straight from the tabloid method.
ken_hoang
Ken_hoang - 2 years ago
@Aintpopularbut: Thanks for your comment. I was surprised as well. Patrick was asked to become CEO by Warren Buffett and had the chance to be around with Buffett since he was the kid.
ken_hoang
Ken_hoang - 2 years ago
Helster1: Please visit : _ http://www.gurufocus.com/news/158043/a-closer-look-at-overstockcoms-frequent-earning-restatements for my post on earnings restatement of the company.
ramands123
Ramands123 - 2 years ago


Thanks Ken for the info.

Here is some more detail on thier business from 10-K.

We deal primarily in discount, replenishable, and closeout merchandise and we use the Internet to aggregate both supply and demand to create an efficient marketplace for selling these products. We provide manufacturers with a one-stop liquidation channel to sell both large and small quantities of excess, closeout and replenishable inventory without disrupting sales through traditional channels, which can result in weaker pricing and decreased brand strength. The merchandise offered on our Website is from a variety of sources, including well-known, brand-name manufacturers. We have organized our shopping business (sales of product offered through the Shopping Section of our Website) into two principal segments—a "direct" business and a "fulfillment partner" business. We currently offer approximately 197,000 non-BMMG products in 19 major departments, and approximately 763,000 BMMG products.
AlbertaSunwapta
AlbertaSunwapta - 2 years ago
They may have had restatements but they also employed some rather conservative accounting practices - I saw that as being a wash.

While I owned it, though, it never seemed to be able to develop any brand recognition or moat. They have to become the lowest cost - high volume retailer and that's a tough task to accomplish. Low costs, with even modest margins but relatively low inventory turnover just doesn't cut it.

In Canada a company called Liquidation World has tried that route for decades but it has only survived, never prospered. Moreover, theses companies are up against bricks and mortar companies like Winners for access to popular brands and when it comes to flogging non-main stream, no-name and other off brands, people generally have a need to see and touch what they are uncertain about.

The naked shorting argument they presented seemed to have considerable validity and the critics that came out of the woodwork to criticize the company were oddly voracious suggesting more than normal levels of vested interest in seeing the company fail. I'd hoped to capitalize on a short squeeze or the lawsuits but eventually walked away from the stock. (I have exposure through FFH and Chou funds.)

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