On Overstock
Why am I writing about an unprofitable internet company on a value investing blog? Because this blog is about finding dollars that trade for fifty cents; with a market cap of less than 75% of sales, Overstock.com (OSTK) looks like it may be exactly that.
But isn’t it too risky?
The greatest risk in any investment is the risk of overpaying. So, the real question is: what is Overstock worth? I think it’s worth at least $1.5 billion. With Overstock’s market cap currently sitting around $500 million, my valuation certainly looks far fetched. But, there’s only one way to know for sure. Let’s take apart my argument piece by piece, and see if any of my assumptions are unreasonable.
First Assumption: Over the next five years, Overstock will neither generate truly free cash flow nor consume cash. In other words, its free cash flow margin will average 0%. Cash generation in some years will exactly offset cash consumption in other years. Obviously, this assumption is unreasonable, because there is almost no chance the cash flows will exactly offset.
That’s not a problem if it turns out Overstock does generate some free cash flow over the next five years. In that case, my assumption simply errs on the side of caution. If, however, it turns out Overstock actually consumes cash over the next five years, there is a problem – possibly a very big problem. So, which scenario is more likely?
Overstock’s revenues are growing quickly. Gross margins look solid at 13.3% in 2004 and 14.9% over the last twelve months. Overstock’s unprofitability is the result of its selling, general, and administrative expenses (SG&A) which have been growing exponentially. Will these expenses continue to grow? Yes, but not as fast as revenues. Over the last twelve months, Overstock’s spending on cap ex has been 5.6% of sales. That number is an aberration. In the long run, spending on cap ex should not exceed 3% of sales. Considering the business Overstock is in and the expected sales growth, the company will, more likely than not, generate some free cash flow over the next five years. Therefore, the assumption that Overstock will be cash flow neutral over the next five years is not overly optimistic.
Second Assumption: Over the next five years, Overstock’s sales will grow by 15% annually. Is this an unreasonable assumption? Again, I don’t think it is. Very few industries are expected to grow as fast as eCommerce. Overstock’s revenue growth in 2003 and 2004 was over 100%. In the past year, that growth has slowed. However, it is still closer to 50% than it is to 15%. Overstock isn’t in a cyclical business. So, there is no reason to believe current sales are abnormally high.
Also, all that spending on advertising is increasing consumers’ awareness of Overstock. A review of Overstock’s traffic data shows it has not only been gaining more visitors; it has also been climbing the ranks of the most popular web sites. While it is a long, long way from the Amazons, Yahoos, and eBays of the world (and will never reach those heights) Overstock is becoming a well known internet destination. This fact was most clearly evident in the weeks leading up to Christmas. Shoppers who visited Overstock during the holiday season obviously know it exists, and may very well return at some other point in the year. Analysts are predicting very high growth rates for Overstock; however, they are also recommending you sell the stock. I don’t put any weight in their estimates. But, for the other reasons given, I believe the assumption that Overstock will grow sales at 15% a year for the next five years is not unreasonable.
Third Assumption: Six to ten years from today, Overstock will have a free cash flow margin of 3%. Ten years from today, Overstock’s free cash flow margin will rise to 4% and remain at that level. Now, of all the assumptions I’ve made, this one is the most questionable. Sure, Amazon has that kind of free cash flow margin, but Overstock isn’t Amazon, and it never will be Amazon. Overstock’s gross margins are less than Amazon’s. In fact, Overstock’s gross margins are less than Wal – Mart’s. However, Overstock’s fixed costs will eat up a much smaller portion of its sales than is the case over at Wal - Mart.
If you compare Overstock to other online retailers, you will see that if Overstock does experience strong sales growth, a 3% free cash flow margin six years from now is not unreasonable. I assumed Overstock’s sustainable free cash flow margin will be 4%. There’s a case to be made that 4% is too high. I won’t make that case, because I don’t believe in it. Remember, that 4% number comes ten years out. That gives Overstock plenty of time to grow sales and thus reduce SG&A as a percentage of sales.
Fourth Assumption: Six to ten years from today, Overstock will be growing sales by 12% a year; eleven to fifteen years from today, Overstock will be growing sales by 8% a year; thereafter, Overstock will grow sales by 4% a year. Let’s see what this really means. According to these assumptions, Overstock’s sales will be as follows:
Today: $707 million
2011: $1.59 billion
2016: $2.71 billion
2021: $3.83 billion
2026: $4.66 billion
2031: $5.67 billion
2036: $6.90 billion
Seven billion dollars is not an unreasonable target – if you have thirty years to achieve it. To put that figure in perspective, Amazon.com currently has sales of about $8 billion. So, even after thirty years, these assumptions don’t lead to Overstock reaching the same size as today’s Amazon. Don’t forget these numbers assume some inflation. For instance, if inflation averages 3% a year over the next thirty years, Overstock’s projected $6.90 billion in sales only translates to $2.84 billion in today’s dollars. So, these assumptions only lead to a fourfold increase in Overstock’s real sales over a period of thirty years. I think that’s pretty reasonable.
If you take these four assumptions together, you get a value of $1.5 billion for Overstock. Today, Mr. Market is offering it for $500 million – that’s why I’m writing about an unprofitable internet company.
Comments
Too bad the CEO tells stories of the Sith Lord...Gotta love his conspiracy theories. I don't trust him as far as I can throw him.
http://jeffmatthewsisnotmakingthisup.blogspot.com/2005/09/is-there-disclosure-issue-here.html
Posted by: stpra123 | January 17, 2006 10:51 PM
I normally try to stay away from commenting on blogs but the last comment was very unintelligent. I would ask the person who left the last comment; how much do you know about Naked Shorting? How well do you know Dr. Byrne? I live in the same city as Dr. Byrne, he gives so much back to our community and to a lot of others as well: http://www.firstclasseducation.org/index.asp
The average investor takes "clips" of information skewed on blogs written by bird watchers http://jeffmatthewsisnotmakingthisup.blogspot.com/2006/01/weekend-edition-friends-of-animals.html and then acts upon the group think, unable to make their own educated decision. That is why Mark Cuban is always telling people to invest in themselves and not the stock market http://www.blogmaverick.com/entry/1234000700073465/
So to wrap this rant up I would say that unless YOU KNOW what you are talking about please leave your uneducated group think to yourself (and out of the market).
Sincerely an investor who is scared of the crooked individuals who have so much effect on the group think called “the value of a stock”.
Ryan
If you want to see something great look at how Dr. Byrne “handles” Jeff Matthews in this clip: http://play.rbn.com/play.asx?url=shareholder/shareholder/wmdemand/hostedfiles/050818ostk.wmv&proto=mms?mswmext=.asx
Posted by: Ryan | January 18, 2006 01:32 AM
I wanted to add one item to my last comment. If you are interested in learning about Naked Shorts I would strongly suggest that you check out www.businessjive.com
Sincerely,
Ryan
Posted by: Ryan | January 18, 2006 01:40 AM
I would be interested in knowing if you believe OSTK is a wide moat company.
I'm no expert but your assumptions all seem rather generous. This is the type of company that I would pass - risk/reward is very high.
Posted by: Evelyn | January 19, 2006 07:30 AM
No, Evelyn, I do not believe Overstock.com is a wide moat company. I simply believe it is selling for less than it’s worth. I should disclose that I do not currently own shares of Overstock, but may acquire them in the near future.
You wrote: “This is the type of company I would pass – risk/reward is very high”. If you are skeptical of the business model and/or future revenue growth (as outlined in my assumptions) I agree with you completely – you should pass on Overstock. I am currently reviewing other material related to Overstock.com and its competitors, largely in an effort to assess this company on qualitative grounds. However, I already suspect I am somewhat more convinced of this company’s business strategy than you are. That’s fine. You’re in very good company. For instance, Shai Dardashti (a value blogger I respect) wrote a discussion board post in which he suggested Overstock was a “seven footer”:
http://www.vinvesting.com/fortopic549.html+footer
This is a rare instance in which I disagree with Shai. I believe Overstock.com is not a seven footer. I like to do an intrinsic value analysis of a company without knowing what the company is selling for. Happily, that’s exactly what happened in this case. The number I came up with was $1.5 billion. Overstock’s market cap is about $500 million. A (67%) margin of safety is rare in today’s market. It is especially rare when the assumptions built into the intrinsic value analysis are extra cautious. I think my assumptions regarding Overstock’s growth considerably understate the growth Overstock will likely achieve. On the other hand, I don’t think my cash flow margin assumptions are overly pessimistic.
Let me give you some ideas of Overstock’s price. Last I checked, the stock was selling at just under 75% of sales; in other words, it had a price – to – sales ratio of less than 0.75. Taking a representative group of about 7,500 publicly traded companies:
43% (3,250) have a price – to – sales ratio of 2 or less.
36% (2,700) have a price – to – sales ratio of 1.5 or less.
27% (2,000) have a price – to – sales ratio of 1 or less.
Of those 2,000 stocks with a price – to – sales ratio of 1 or less only about 38% (750) are expected to grow earnings by 5% or more during the next 3 – 5 years. I don’t pay attention to these analysts estimates; I just wanted to make clear why a company sells at a price – to – sales ratio of less than 1. Usually its sales aren’t growing; often, its sales are shrinking.
To put this into more concrete terms, let me give you the first company for each of the first ten letters of the alphabet that passes the screen (price/sales less than or equal to 1 and consensus EPS growth greater than or equal to 5%):
Alcoa (AA): Aluminum
Barnes Group (B): Industrial Components (for aircraft engines, turbines, etc.)
Cabelas (CAB): Hunting related retail
Darling International (DAR): Cattle rendering / grease tap service
EGL Inc. (EAGL): Freight forwarding, warehousing, etc.
Ford Motor (F): Cars
Greenbrier Companies (GBX): Manufactures and leases railcars
Hastings Entertainment (HAST): Regional multimedia entertainment retailer
Integrated Alarm Services (IASG): Provides services to security alarm dealers
Jarden Corp (JAH): Consumer products
Now, there are a few very interesting stocks that come up on this screen along with Overstock. For instance, there’s Jakks Pacific (JAKK), a toy company I mentioned in my latest post:
http://www.gannononinvesting.com/2006/01/on_the_rationale_for_the_overs.html
Jakks is a company I will probably write about in the future. Many of these other companies, however, are in highly competitive, no – growth businesses. Some of them carry far too much debt. My point is simply that it is unusual to see a company with as promising a future as Overstock’s trading below sales.
I must admit, however, that the answer to your question (is Overstock a wide moat company?) is an emphatic no. High volume businesses do have high barriers to entry (they are unprofitable for a while). Advertising costs are also less per customer on the higher volume. However, Overstock is not yet very big, and right now it isn’t turning a profit. Competing in this space unprofitably is something anyone can do.
Thanks for the question. I hope this offered some clarification.
Posted by: Geoff Gannon | January 19, 2006 03:17 PM
When I wrote this post, I wanted to leave Patrick Byrne out of it. Management is a factor in the analysis of a company’s stock; however, much of the coverage of Dr. Byrne has been overly sensationalized. I did not think this blog’s readers would benefit from my rehashing of that topic or from the comments such a post would likely receive. However, there have been some comments regarding Dr. Byrne. As a few readers may not be familiar with Overstock’s President, or may have only heard about the lawsuit, I’ve decided to include a few links with information on Dr. Patrick Byrne:
From Overstock:
http://www.shareholder.com/overstock/bios.cfm?bioID=1890
From First Class Education:
http://www.firstclasseducation.org/charimanremarks.asp
If you want to hear the other side of the story simply type “OSTK” into Google Blog Search. An example of this kind of coverage was cited in an earlier comment; I reprint it here for the sake of fairness:
http://jeffmatthewsisnotmakingthisup.blogspot.com/2005/09/is-there-disclosure-issue-here.html
I do not have a lot to say about all this. I do not know Dr. Byrne. Of course, I do not know most of the managers of companies I write about or invest in. Dr. Byrne has, through some of his actions, demonstrated a management philosophy I agree with. I wouldn’t mind seeing managers of other public companies emulate him. However, this does not mean he is a great manager; nor, does it mean Overstock will succeed.
As to the issue of naked shorting, it is a valid concern. It is also a matter about which I know next to nothing. I do not wish to say anything about it generally or in this case specifically. I don’t think anyone knows enough specific details to speak to this case. In time, we will know more.
I understand Dr. Byrne’s point of view. I know why he feels he has to do something about this. I must say I would never go about it the way he has; but, that doesn’t necessarily mean he is wrong.
Personally, I am more interested in Overstock as a business than Overstock as a news story. That doesn’t mean it’s an uninteresting story; it just means I’m an investor.
While trading in Overstock is a story worth reading about, because it may have implications behind this one stock, it is not a story I feel qualified to write about. Other outlets are better suited to this sort of thing. I’ll stick to analyzing and valuing the business.
Posted by: Geoff Gannon | January 20, 2006 01:02 AM
Thanks Geoff for your comments -I understand your reasoning. When I study a company I just prefer to start with trying to identify if I am looking at a quality company. If its not in my mind a quality company I move on. Cheap stocks are often cheap for a reason. Time will tell if OSTK is the proverbial falling knife.
Let's say you purchase OSTK - how long would you wait for the co. to become profitable or see some degree of improvement? Or what is your philosophy on selling. I find it sometimes easier to buy a company than sell it.
Thanks - Ev
Posted by: E | January 20, 2006 07:13 AM
First, your questions. Then, some answers.
"Let's say you purchase OSTK - how long would you wait for the co. to become profitable or see some degree of improvement? Or what is your philosophy on selling. I find it sometimes easier to buy a company than sell it."
I would be willing to wait a long time for Overstock to turn a profit, because of the company’s strategy. I don’t think it needs to show any signs of improvements, it just needs to maintain its trajectory until it reaches a sort of critical mass.
The metrics worth watching are often particular to the company and its business model. For Overstock, I’d watch three metrics very closely: revenue growth, gross margins, and traffic data. Revenue growth and gross margins are given in official filings. Traffic data is available free from independent parties (e.g., Alexa).
As far as revenue growth, it must stay well north of 15%. If there are real concerns revenue growth is slowing enough to drop below 15% annually within the next few years, I’d be concerned. I don’t think that’s the case now.
Gross margins that fall between 12 -15% wouldn’t concern me at all. Gross margins much to the north of 15% would be a bit of a concern, as Overstock.com is all about low prices. I’d worry that gross margins above 15% could indicate management’s willing to sacrifice long – term opportunities for short – term profits. I don’t think that makes sense in Overstock’s case. You can make a good argument for Overstock as a low price, high – volume internet retailer. It’s hard to make a case for Overstock as just another internet retailer.
Gross margins below 12% would get my attention. It would take an awful lot of volume to reach the kind of free cash flow margin targets (3% and 4%) I’ve given for Overstock, if gross margins stayed below 12%. If gross margins rose above 15% or fell below 12% for a brief period, I wouldn’t be concerned. However, if there was a real reason to believe they might stay there, I’d have to take a good look at my free cash flow margin assumptions, and thus another good look at the stock.
Traffic data is really more of a qualitative concern than a quantitative one. I’d ask three questions here: Is Overstock’s traffic rising? Is Overstock’s traffic rank rising? What does Overstock’s Christmas shopping traffic look like?
The total amount of traffic should definitely be rising. Just about any website can accomplish that with the growth in internet users. Overstock’s traffic rank should also be rising. It should be growing traffic faster than its competitors. Finally, I’d be discouraged by weak Christmas traffic numbers.
So far, I’ve been encouraged by Overstock’s traffic numbers. You can also look at the most visited shopping sites. Surveys will put this sort of information out around Christmas. You want to see Overstock separate itself from the pack. It doesn’t have to stand up against Amazon, eBay, etc. – it just has to have a recognizable name and become something of an internet shopping destination.
As far as waiting for profitability, I’m more concerned with cash flow. Watch both operating cash flow and free cash flow, but pay more attention to operating cash flow. As Overstock grows it will have wildly different free cash flow numbers based on when it chooses to make certain expenditures. Within the next five years or so, this should stop happening. For the next few years, however, free cash flow won’t be a very accurate measure of the company’s inherent profitability.
Start by looking at operating cash flow. By using estimates of how much working capital was added because of revenue growth, you can get some idea of how much free cash flow Overstock would have had if it wasn’t growing. This is always a useful figure. With a growing company, you need to look really hard at the relationship between sales growth, cash flow, and working capital. With Overstock, as with many companies, you should spend more time with the balance sheet and statement of cash flows than with the income statement.
As long as, after reviewing these numbers, I thought Overstock wouldn’t have trouble meeting the assumptions I laid out, I would hold on to the stock or buy more. If there were problems with these numbers that cast some doubt on Overstock’s ability to meet my four assumptions, I would sell the stock. Right now, Overstock is on track to easily match my assumptions according to the metrics I outlined above.
The only reason to sell a stock like this is that your original analysis was incorrect. In this case, that means my assumptions were too optimistic. That’s what I’ll be looking for.
(As I mentioned before, I don’t currently own shares of Overstock, but may acquire some in the near future. I won’t be making this kind of disclosure all the time, I just wanted to make it clear in this particular case).
If anything I’ve said in this post is unclear, or you would like me to explain how to perform any of the calculations I suggested, please post a reply with your questions or send an email to geoff@gannononinvesting.com. I would be happy to write a full post about some of the metrics I mentioned or about certain analytical procedures like looking at working capital with an eye to how it was affected by revenue growth. If you feel anything like that would be helpful, let me know.
Posted by: Geoff Gannon | January 20, 2006 01:33 PM
Ryan - "So to wrap this rant up I would say that unless YOU KNOW what you are talking about please leave your uneducated group think to yourself (and out of the market)."
PLEASE DON'T EVER TELL ANYONE THAT AGAIN! I personally want a bunch of uneducated group thinkers in the market. :-)
I don't naked short, but I don't see anything wrong with it, AS LONG AS the shorter can produce the stock within the settlement time.
That a CEO is worried about the stock price and impact of short-sellers is further evidence of either (a) the agency problem, (b) incorrect CEO compensation methods, or (c) both. All stock prices get manipulated from time to time, to a degree, even by shorts that actually HAVE borrowed the shares. Big deal! Don't hate the player, don't be a player-hater, hate on the game instead.
On "giving back" - that's just good PR for a CEO. Find a CEO that DOESN'T do stuff like that.
Disclosure: I'm neither long nor short Overstock, and I haven't done my own analysis of the stock's price, but I really think that gal in the commercials is hot.
Posted by: nodoodahs | January 20, 2006 02:11 PM
Geoff,
You project Overstock having $1.59 billion in revenue in 2011, and a 3% free cash flow margin at that point (which works out to $48 million in FCF).
What do you think is a sensible multiple to place on that $48m in FCF?
It would take a multiple over 31 to get to the $1.5 billion valuation target you mention. This seems quite high to me for a 15% grower. Am I missing something?
Posted by: Jim | March 6, 2006 06:17 PM
Jim,
No you aren't missing anything. The inverse of a multiple of 31 is a cash yield of 3.23%. That is low, but with a discount rate of 8% and a growth rate of 15%, Overstock's "coupon" would be growing quickly in 2011.
Even if the FCF margin remained at 3%, by 2016, the "coupon" has grown to 5.42%; by 2021, it has grown to 7.66%; by 2026, it has grown to 9.32%; by 2031 it has grown to 11.34%; by 2036, it has grown to 13.8%.
Of course, in my projection, I increased the FCF margin assumption to 4% after a brief period of a 3% FCF margin. This results in somewhat higher yields.
One big question is how much of the free cash flow is being reinvested in the business. I believe, several years from now, it will take very little investment by Overstock to generate the amount of free cash flow discussed.
A multiple of 31 is high, but not as high as it sounds. A review of many growing publicly traded companies will reveal they have free cash flow yields that will quickly fall behind the yield discussed in this model.
I don't think a multiple of 31 is particularly high for a 15% grower, if we're talking about free cash flow.
On the other hand, it is true you can find companies with a current FCF yield of 10%+; but, many of these companies actually have shrinking revenues, or cyclically high free cash flow yields.
Coupon growth is important. For instance, to justify a truly static FCF "coupon" I would probably require about a 12.5% (current) FCF yield; in other words, a multiple of 8.
The danger is not so much in accepting a 3.25% yield for a 15% grower or a 12% yield for a 0% grower. The danger is usually in accepting a 4-5% yield for a slow grower. At least that has usually been my experience.
People get in trouble when they look for a decent company at a decent price. They may feel justified in paying 20-25 times free cash flow. However, if you do the math on the "coupon" growth, you will see that accepting 3% for a fast growing coupon is often a better bet than accepting 4-5% for a slow growing coupon.
Obviously, you could go the other way and look for a coupon so high (like 12%) that you can do well without any real growth. The trouble in both cases, the fast grower and the no grower, is sustainability. If the no grower's revenues decline, you're in trouble. Likewise, if the fast grower's growth rate declines, you're in trouble.
Anyway, you aren't missing anything. As strange as it sounds, a FCF multiple of 31 does not seem unreasonable to me. By the way, this is one of the reasons I prefer using the inverse (the yield). Using a multiple tends to affect one's psychology in an undesirable way.
For instance, the difference between a FCF multiple of 8 and 12 (like the difference between a P/E multiple of 8 and 12) does not look huge, but it is. I think this leads to a lot of people paying 4-5% or 20-25 times free cash flow for businesses that do not offer a real margin of safety by providing a growing coupon.
Posted by: Geoff Gannon | March 6, 2006 08:10 PM
Hi Geoff,
Great discussion on OSTK. You also mentioned you are going to talk about Jakks Pacific in future discussion. I am really interested in the company, but there are some red flags(after reading 10k-q) related to the company law suites with WWE and also stock compensation to execs and directors. Can you give your insight on the company? I am also interested in your subscribing your newsletter, but the price is too much for me..is there any kind of discount you can give?(may be I am looking for buying thing which worth 1$ but sells for 50Cents-sounds familiar!!).
Thanks very much,
Sanket Desai
Posted by: sanket desai | August 13, 2006 11:24 AM