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.
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.
|Operating Cash Flow||-10||2||-10||25||-6||-26||10||2||46||16|
|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%.
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