On Overstock's Terrible Third Quarter
I did not expect to learn anything significant about Overstock.com (OSTK) until the fourth quarter results were in, because the Christmas season is so critical to the company's success. However, Monday's announcement of a year-over-year decline in revenue was completely unexpected.
Based on Byrne's remarks and the reported results, it looks like Overstock got everything right except conversions. I was pleasantly surprised with how well the company managed its IT systems and its inventory. In the past, management had made mistakes in these areas and Overstock paid the price. This quarter they did a great job on both fronts.
Unfortunately, the fantastic growth that had allowed Overstock to move forward despite serious missteps (in previous quarters), was totally absent this quarter.
In his letter to owners, Byrne wrote:
"In the past we ran at an A- and regularly generated 100% growth: now I think we are running at an A+ but seeing no growth. I am not entirely sure what to make of that."
I agree. That's the real story. The company gave its best performance – and posted its worst results. The CEO can't explain it and I can't either.
At the beginning of this year, I thought Overstock could grow sales at 10-15% for the year. I expected to see total sales for 2006 of between $875 million - $925 million. In the first three quarters of 2006, the company only generated about $500 million in sales. So, Overstock would need $375 million to $425 million in sales during Q4 to get to where I expected them to be at the end of the year. To put that in perspective, the company had sales of $318 million in Q4 of '05.
So, Overstock would need to post year-over-year growth of 18 – 34% during the fourth quarter of this year just to reach a target I thought was sufficiently conservative when I set it about a year ago.
Then, there's the issue of cash. Like I said, Overstock did everything right this quarter and still posted very poor results.
In February, I wrote that "Insolvency could only occur through gross managerial ineptitude". Clearly, I was wrong. Overstock's management is not inept; in fact, they've made meaningful improvements to the business in the first nine months of 2006. Overstock is a much more efficient operation today than it was a year ago.
However, there is a real risk of insolvency. If Overstock's fourth quarter results don't show year over year growth of at least 15-20%, it seems nearly certain they will have to raise cash in 2007.
Even if the fourth quarter looks great, there may be a need to raise cash. If the company has to raise cash while its prospects appear terribly dim, the terms on which the cash is raised are likely to be extremely detrimental to current shareholders.
Overstock has a solid business model. Unfortunately, the logic of that model is predicated upon sales volume growth. The business simply can't operate profitability on such a small volume. If Overstock can't grow sales, it can't survive.
If we see really poor sales growth in the fourth quarter, despite Overstock's excellent name recognition, I would have to question the firm's viability. If the company reports year-over-year growth in the single digits for Q4, I'd have to seriously question whether this is a viable business.
The third quarter results (themselves) are unimportant. But, the fact that revenue declined going into the critically important fourth quarter is both surprising and unsettling. I never imagined a quarter could be this bad. Clearly, I don't understand the business, because I really did believe a year-over-year decline in sales was unthinkable. These results shake the foundations of my case for Overstock.
Now, the natural question is whether the stock is (in my opinion) a buy, sell, or hold. That's not the way I usually discuss stocks on this blog – and it's certainly not the way I'm going to discuss this stock. I've already demonstrated I don't understand the business; if I did, I would have been able to see that Overstock could experience a year-over-year decline in revenue despite strong brand recognition. I didn't recognize that possibility; so, clearly I don't understand the business.
Having said that, I am aware of the dangers of announcing my lack of confidence in Overstock (and thereby reversing my earlier pronouncements) at precisely the time the stock is making new lows. On the basis of price-to-sales this remains a very cheap stock, if the company's growth prospects are reasonably good.
Based on the site's traffic and customer awareness, I was convinced Overstock's growth prospects were good enough to justify purchasing the stock. Now, I'm not sure, because any failure to grow sales will result in insolvency. I thought the likelihood of such a failure was extremely low; now, it looks like a real possibility.
It's clear I don't understand this business. So, personally, I'm unwilling to own it. I can't assess the risks of owning shares in Overstock.com. If I can't assess the risks, I can't own the stock – it's that simple.
However, I can't, in good conscience, encourage others to sell at levels that present the possibility of great rewards if Overstock achieves merely mediocre business results.
Furthermore, I had no intention of writing about this stock until the fourth quarter results were in, because I believed those results would be the only ones I could learn anything meaningful from. I still believe the fourth quarter results will be the most important piece of information we receive. But, that would mean a long wait.
There is certainly no assurance that Overstock's share price will decline. In fact, being short the stock (today) presents greater risks than being long the stock.
If some evil omnipotent were to force me to choose between being short the stock by x dollars or being long the stock by x dollars, I would certainly choose the latter. It's a lot easier to sleep when your liability is limited. A short stake creates an unlimited liability (in dollar terms). So, where a huge price movement in some direction is almost certain (as it is in the case of Overstock), it's safer to take the long side. Here, my point has nothing to do with short-term price movements. It has to do with Overstock's precarious position.
Overstock will either survive or it will fail. If it survives, it would be nearly impossible for the stock to trade much below this level. In fact, if the business survives, the stock price will very likely have to rise by several hundred percent in any market. Obviously, if the business fails, the stock will be worthless.
Is Overstock a good bet? I don't know. Is it a safe bet? No.
Related Reading
An Analysis of Overstock (OSTK)
Comments
That's what I like about your blog Geoff. You are not afraid to revisit an analysis and perform a critical analysis.
Posted by: Steven | November 8, 2006 08:29 PM
Geoff,
Great analysis again. But I am now little bit cautious about Byren, he is honest(that's great but we r not investing just in honesty but actual company) but during the call the whole management sounded pessimistic. One of the things I noticed is conversion rate is low since Byren took that responsibility- one quarter can't be taken as measurement for his ability to improve it. I will give 2 more quarters-specially this 4th quarter. Though one thing I would like to ask Byren is "if he would be still running Buffett's company,will Buffett keep him in the job after 2-3-4 quarter like this?" I didn't like his answer about why they don't know why the visiting customer didn't become paying customer. If you r working for someone(in this case for shareholders) this kind of answer will give chill in the bone to that person(or in this case shareholders). Let's see what happens in next few Qs.Will be bumpy ride for sure!!
Posted by: sdesai | November 8, 2006 11:33 PM
I agree with your concerns about Byrne. However, there is a natural (and detrimental) tendency to prefer unreasonable answers to no answer at all. I've heard many executives make excuses that couldn't possibly explain their poor performance, rather than admit that the failure was in an area they could control. At other times, I've heard some managers (including the CEO of a prominent homebuilder) admit they are caught off guard by something that seemed terribly obvious. In the case of conversions, it was a real surprise to me. Obviously, the problem is specific to Overstock and is the result of some managerial misstep.
I was prepared for missteps, I just wasn't prepared for the result. I thought the company could make quite a few mistakes and still enjoy some year-over-year growth. That isn't what happened this quarter. So, in some ways, the fact that this was not the result of conspicuous managerial mistakes is what makes it so unsettling. The third quarter results weren't merely disappointing – they were baffling as well.
I agree with the importance of the fourth quarter. I still think we won't know what kind of shape the company really is in until we see the results from the Christmas shopping season.
I've always been unimpressed with Overstock's understanding of its customers and their actions. They don't seem to have a great grasp of some of the data I would want to see if I had to make these decisions. I think the conversion problem is dependent on management understanding more about visitors to the site. Really studying (visitors/customers) has been a weakness for Overstock – and it's been the weakness that bothered me the most, because it seems the least forgivable. I can understand implementation problems; I can understand poor inventory management. You can imagine making those same mistakes if you were running a company that was growing as fast as Overstock was. But, the lack of real understanding regarding visitors to the site is not a mistake I understand.
Finally, while Byrne deserves criticism, I hope he is criticized for the right reasons and not for anything he wrote in his letter. Management's results have been very poor; however, it's efforts to communicate those results and to explain the business to its owners have been very good. Obviously, that doesn't add any value to a bad business. But, it's easy to learn the wrong lesson here – make your mistakes in private, keep quiet, and opt for the most generic disclosure possible. There are a lot of miserable CEOs out there. They don't get the same criticism, because they don't draw the same attention. So, I hope the criticism is focused on the mistakes (like the one I outlined in the above paragraph) rather than the manner in which Byrne conducts himself.
Posted by: Geoff Gannon | November 9, 2006 12:11 AM
A good, honest assessment of the predicament an investor in OSTK faces.
One thing missing in the beginning of any post on this blog was a true assessment of OSTK's competitive advantages or lack thereof.
I believe OSTK lacks competitive advantages therefore its only strategy is to be run as efficiently as possible. However, with a CEO like Byrne who lacks lazer like focus on the business, I wonder if that is possible. At least the Byrnes will go down with the ship.
I do agree that this is an option.
Posted by: John Chew | November 9, 2006 07:13 AM
I think the key is the risk of invsolvency, which has been mentioned before. Keep in mind there is no price low so low that it can't get lower, and no price so high that it can't get higher. While I've been generally bearish on OSTK over the last year, I've not committed any money to that and at this point don't imagine I will.
I still think the gal in the commercials is just a buttered biscuit. Rowr!
Posted by: Bill a.k.a. NO DooDahs | November 9, 2006 10:42 AM
I feel, they should add new domain name, a better Sounding name .The brand name 'overstock' is not impressive for anyone who is searching for quality goods, though they sell quality materials .
The IT cost would be same if they register or buy a new domain and start selling parallely .
Just two instance of the same server with same content in two domains .
Posted by: John | November 10, 2006 01:07 AM
Yes, this one has really messed up. What looked like a perfect combo - the Byrne genetic inheritance, the cost discipline, the sales explosion - became the perfect storm. Debt, stagnant sales and margins and a distracted CEO all did their bit but maybe the concept simply hit a wall.
Your conclusion is spot on, by the way. If it survives its cheap. There is a probably a clever hedge trade to game this, but too clever for us.
Posted by: StockReply | November 22, 2006 11:30 AM
Someone posted an incredible powerpoint on naked shorts and no deliverable settlements on our site. FYI, I have no relation to Patrick Byrne. However, my name is Brendan Patrick Byrne.
Posted by: Brendan P. Byrne | November 26, 2006 05:11 PM