Overstock.com, Inc. (OSTK)
Q2 2006 Earnings Conference Call
July 28, 2006, 11:00 am ET
Patrick Byrne - Chairman and CEO
Jason Lindsey - President and COO
David Chidester - Senior Vice President, Chief Financial Officer
Aaron Kessler - Piper Jaffray & Co.
Scott Devitt - Stifel Nicolaus
William Lennan - Wedbush Morgan Securities, Inc.
Frank Gristina - Avondale Partners
Shawn Milne - Friedman, Billings, Ramsey Group, Inc.
Good day, ladies and gentlemen, and welcome to the second quarter Overstock.com earnings conference call. My name is Jennifer and I will be your coordinator for today.
At this time, all participants are in a listen-only mode. We will conduct a question-and-answer session toward the end of this conference.
As a reminder, this conference is being recorded for replay purposes.
I would now like to turn the call over to David Chidester, Chief Financial Officer. Please proceed, sir.
Thank you. Good morning and welcome to Overstock.com’s second quarter 2006 conference call. Participating with me on the call today is Dr. Patrick Byrne, Chairman and CEO of Overstock.com; and Jason Lindsey, President and Chief Operating Officer.
Before I turn to my financial summary, please keep in mind that the following discussion and the response to your questions reflect management’s views as of today, July 28, 2006 only.
As you listen to the call, I encourage you to have our press release in front of you, since our financial results, detailed commentary, and the President’s letter to shareholders, are included and will correspond to much of the discussion that follows.
As we share information today to help you better understand our business, it is important to keep in mind that we will make statements in the course of this conference call that state our intentions, hopes, beliefs, expectations, or predictions of the future. These constitute forward-looking statements for the purpose of the Safe Harbor Provisions under the Private Securities Litigation Reform within the meaning of Section 27A of the Securities Act from 1933 and Section 21E of the Securities Exchange Act of 1934.
These forward-looking statements involve certain risks and uncertainties that could cause Overstock.com’s actual results to differ materially from those projected in these forward-looking statements. Overstock.com disclaims any intention or obligation to revise any forward-looking statements. Additional information concerning important factors that could cause actual results to differ materially from those in the forward-looking statements is contained from time to time in documents that the company files with the SEC, including but not limited to its most recent reports on Forms 10K, 10Q, 8K, and F1.
With that, I would like to discuss our second quarter results. Please note that all comparisons will be against our results from the same quarter last year, unless otherwise noted.
Total revenue was $160 million, an increase of just over 6%. Gross margins were 14.4%, down 70 basis points from last year but up 40 basis points over Q1.
Gross profit dollars remain flat at $23 million.
Sales and marketing costs were 7.6% of sales, down 200 basis points from 9.6% last year. This is a reflection of a 16% decrease in overall marketing expense year over year.
Technology and G&A expenses combined were 17% of sales in the quarter compared with 9% last year. While we anticipate both technology and G&A expenses to flatten going forward, we will continue to see difficult year over year comparisons for the next two quarters.
Total operating expenses were flat quarter over quarter at $40 million, which represents 41% growth year over year. This translated into a $16.7 million operating loss for the quarter, or 10.4% of sales.
Our net loss was $15.8 million, within our expected range of $14 million to $18 million. This equated to 9.9% of revenue and a $0.78 loss per share. The net loss was less than our operating loss, due to a non-operating gain of $1.9 million we received from liquidating our $50 million of foreign currency bonds during the quarter.
In addition to selling the bonds, the company raised $25 million by selling just over a million shares of common stock in early May.
Our cash balance at the end of the quarter was $46 million, with an additional $30 million of availability on our inventory line.
Operating cash flows during the quarter were an outflow of $6 million and free cash flows were an outflow of $12 million.
For the trailing 12 months, cash flows from operations were an outflow of $40 million and free cash flow was an outflow of $72 million.
With that, I will turn the call over to Patrick.
Thank you very much, David. Financial results are right down the middle of where we thought they would be. Again, I am sorry. About this time last year is when we were coming off the -- well, started coming off the rails. It is going to take us into the third quarter to get everything back on.
The projects we have been working on to improve the business are progressing nicely. I will be getting into that, but basically we had 20 projects we expected to finish by the end of June. We finished 13 of them and we have another six that we should wrap up, actually, we will check off today.
The infrastructure we have in place is almost ready for us to go back and hit the go-fast switch and start accelerating again. I think we are really sort of four to eight weeks away from saying okay, we got through that, we got things back on the rail and it is time to hit the go-fast switch.
I am going to go to the -- you should have a webcast screen in front of you. you control your own slides. I will just call out the page that I am on. We have made this really simple this time, so there is no lag and so forth.
Page two, there is a safe harbor, basically identical to what Dave Chidester just said.
Go to page three, management changes. Some were described in the letter. The old-timers here remember Jason Lindsey, and I think welcome Jason Lindsey. Jason has actually been -- I think he was president for about two months and then had to retire for some personal issues, but since then he has actually been involved in the business and stayed on a one-day-a-week capacity. He has come back as President and has taken specific responsibility for the buying team. I have taken over the internal marketing personalization, e-mail -- we call it internal marketing as opposed to online marketing and offline marketing, so the website, everything related to customer analytics.
Page four, operations update, I will be talking about order flow management, customer care, and inventory management. I think just the bottom line is what you are going to see is a business in -- I have made no bones about it. We came off the rail and we had a lot of fixing to do, but everything has gotten stitched back together pretty nicely. We are getting out of rehab and ready to start walking, I would say, knee rehab [inaudible] knee rehab, and we had a [inaudible] or something where we are ready to start walking again, if not running. You will see what I mean.
On page five, and Jason can talk to this more, we actually call this customer aggravation points internally, order flow management. I have described this before in a couple of settings, but it basically -- there are about 17 things that have to be done from the time you push enter my order, submit an order, to the point that something shows up at your home. 17 things have to go right, but some things may not go right and it does not -- for example, if you do not get an order confirmation e-mail, that is not good but it is not as aggravating as not getting your package, or not having tracking information is aggravating but not as much as not getting your package.
So we rate those with different numbers and points and then if something is a 5-point problem and it is 20 days old, then that is 100 points of aggravation. We started this when we had our big problems last fall, and it was literally in the million. It has come down to 20,000. In fact, it should be under 10,000.
What this means is that the problem is 99.5% cleaned up. In fact, the Japanese have this metaphor when you are fixing a manufacturing problem, you drain the lake until some rocks emerge, and then you stop and you fix the rocks, and then you drain the lake some more until some more rocks emerge.
What this has let us do is -- that is the approach we have taken to this, and we have just drained the lake so far, it is so -- I mean, this really comes down to a few dozen orders. It could be some e-mails that did not get sent or something, but it means that things have gotten so drum tight and for comparison, if we go back and reconstruct where we were when we thought, when things were going great, we were going 100%, this was probably around 100,000 points.
In other words, if you are sending out a million orders a month, or a million packages a month, then if you do something wrong to a thousand customers, that can easily turn into a few 100,000 aggravation points. So we have this -- our process is much tighter than it was even before we made these system changeovers.
What happens is we keep on getting it down to close to under 10,000 and in the process discover here is one other little crack that it is possible for something to go wrong, and then we go and fix that, but the things that we -- and our data is so granular now, the things that we can turn up are getting tinier and tinier problems.
This has been Jason’s effort, along with taking over merchandising.
Slide six, I talked about our NPS score last time. That stands for net promoter score, and there is a book out by Fred Reichheld, The Ultimate Question, and I notice since I have mentioned this, I am starting to see a lot of people talk about it, Reichheld is the guy who wrote -- he is a [inaudible] consultant who wrote The Loyalty Effect, which sort of set in motion the CRM movement.
This is a relatively new book by him. The ultimate question you want to ask about any company is would you recommend this company to a friend, and have people score you one to ten. Consider nine to ten people who score you nine to ten, promoters of the company, one through six are people who are going to detract, slag your reputation, seven’s and eight’s are neutrals. If you subtract the nine and ten’s from -- if you subtract the one’s through six’s from the nine’s and ten’s, you end up with your net promoter score, what percentage of the people that deal with you are going to go out and say “Hey, I had a great experience.”
Ultimately, he makes an argument that this is the most basic, fundamental question you could ask about how well a company is doing for its people.
I go into this detail because I mentioned this last time and people have asked about it. For reference, he says in that book that the average net promoter score of an American company is 8% to 10%, and that the superstars -- he has a list of about 20 superstars in his book who score 40 to 70 -- I think, maybe mid-70’s.
I will now go to slide seven. I put a scale on this, this time so you could see. We were up in the 70’s. We fell, if you look at what happened, we did our implementation last August, November -- things really collapsed. It says that we fell to only 38, which is still a very high NPS. I think that was a lot of good will from our customers.
That may have been people, because if somebody has ordered from you 10 times and over a few years and then you do something, you screw up once, they are going to -- in truth, I think that our NPS score from new customers was probably quite a bit lower. It could have been zero or lower. It has rebounded, as you can see.
We have a pretty complex situation. The only other people I remember from the Internet in that superstar list were Amazon and I think Barnes & Noble as etailers. I would point out that it is a little bit harder to do what we do than it is to send books. In other words, if you get a book to somebody in a timely way, they tend to be happy. We see that in our own customer satisfaction, when people are buying books and movies and videos and stuff, it is easier to satisfy them than if you send them a lamp. A lamp could be broken, so we said this is our goal to get over 60. We are over 60, which is, according to Fred Reichheld’s book, a fantastic score.
I think there may be ways to get this over 70.
One of the great things about our -- I know I go on and on about this data warehouse, but we have such granular detail, so we can see what customers are scoring us lower and what do they have in common. Do they have in common that they ordered lamps or a certain type of lamp? Or ordered from certain partners who did not ship properly, or is it because our -- we are breaking it down to the sku level, and the satisfaction and dissatisfaction by sku, and then it has been fantastic.
We have discovered okay, here we are shipping out some furniture, and the dissatisfaction -- disproportionate dissatisfaction, and we discover it is really the packaging. So we went to the warehouse -- we have a warehouse in Indianapolis and we changed the whole way we package it and returns in that drop 50%.
So it is the granularity of data we have that is going to keep us busy for the next -- it means that we can drain the lake another 10 feet and find a lot more rocks to fix.
Moving on -- that may be more detail than you wanted. I get excited about this stuff. Page eight, brand recognition. This is among all consumers. We tend to dip, as you can see, from Christmas to the first quarter. That has happened again, but we have built a nice brand. It is not obviously as established as Amazon’s yet among all shoppers, but if you go to slide nine, you see among web shoppers, it is really quite outstanding. We have gone from 26% to 65% now, so we have built a good brand. Again, you do see that drop off from December to April, but that is normal, looking back through the years.
Slide 10, GAAP inventory terms. We were just generally making improvements until we got into our troubles, but we are climbing out of it. Again, this picture represents a lot of things. We had a good business going. We stumbled, but we are picking ourselves up, dusting ourselves off, and getting back up to speed.
Incidentally, I know a few years ago I opened a letter saying the rhythm of the Dow is like the drawing of a bow. For example, we in our margins, our gross margins, sort of built up the capacity to get better, and then suddenly, over the space of a year or 18 months, they surge 5 points.
I think the same thing is happening with our gross margin and with our inventory terms. I think that, given our new granular data, we are going to see, starting within a couple of quarters, a dramatic increase in inventory terms and margin.
Marketing efficiency, we spent 19% less, have 8% more sales year-to-date.
Here is something we call nectar. I think contribution margin is the official term, although people use contribution margin differently, but basically gross profit minus marketing expense. I would like to see this get over 10. When this gets over 10, we will have a nice real business. I do think that is possible.
IT project update -- there are really three levels. I will not go into as detailed an explanation as I have done before, but just think of our website as a stack of three systems.
There is the whole shopping database, which is Oracle-based, and there is the ERP system, which handles the orders and sends them to the warehouses, and then there is the enterprise data warehouse.
The shopping database we upgraded from Oracle 9I to 10G. That is a big deal. That was the last of our big IT projects. Oracle 10G, for those who are tech investors, Oracle 10G, at the risk of being cynical, -- well, a cynic would say it delivers what 9I promised, but be that as it may, it is the real thing. It is great. It is so much more robust, faster recovery times, a cost-based optimizer, which means that when you run queries, it runs appropriately -- it is just so much -- it is a great system.
ERP -- our capacity was 10,000 orders an hour under the new system we installed last August. That was problematic because I think we capped at 8,000 orders in an hour sometime in the last Q4. That was again a factor of the hurried installation, the rushed installation.
We had an outside consulting firm come in for a couple hundred thousand dollars, look at this, there is about 5,000 settings in the database, and they spent six months studying it, and then they gave us this is how you should set these 5,000 settings, we did it and we now have theoretically 150,000 orders an hour capacity. I mean, we stress-test it to that. That means, even if you say 100,000 to 150,000, it is about 15 times the demand that we went during the last year’s fourth quarter. So that layer is set for a long time.
Then the data warehouse, we have super-sized it with a new system. I think I will leave it to Teradata. They are going to be announcing sometime soon what they have done here, but they have super-sized the system. That is important for a bunch of reasons.
We are now personalizing e-mails, but we have trouble personalizing more than about 500,000 e-mails. We send nearly 10 million. We have 22 million addresses, but we send 10 million three times a week. We could personalize about 500,000. We are actually through -- some brains in the IT group I think figured out a way to get that to 2 million, but with the super-sized system, we will be able to handle a lot more, and we are very glad we upgraded.
So put together -- and that new system actually is in-house, it is in -- we are failing over I think -- we are running in parallel then switching over to the new system in a couple of weeks.
So put together, we have now finished our transition from a company that was running on a bunch of homegrown systems that we wired together that worked and carried us for a long time but were just keeping problematic -- keeping alive was getting increasingly problematic and now three industrial -- all three tiers are big, industrial-strength, rock-solid systems.
This first year we have actually been ready from a capacity standpoint. We have been ready for Christmas, we were ready in July.
Slide 14, Propeller -- there is a slight altering of course. I do expect that [inaudible] on August 10th, the night of August 10th, we are going to roll out Propeller. Now, these things can slide, but I have taken over these issues and would be happy to answer questions about this.
By the way, Holly decided -- Holly was running this for six months, but she decided for her own personal reasons -- it has been a long five years for her, and she decided to step down, but I have been looking forward to taking this over.
Other projects, the warehouse mezzanine is now finished. It cost us -- let’s say it cost us X to pick a package, and say that one picker can do T ticks in an hour in our normal warehouse. In the new mezzanine, they can do about 140% of T, and the effect on X, the cost, is going to be to eliminate about, because ticking is one aspect of X, a component of X, it should be enough to knock about a third, or maybe 30% out of X. So that translates into a -- I am so excited about the mezzanine, because it is not going to give us a full percent margin, but maybe half a percent margin. We are already running out of it very nicely, we are getting about 41% of our picks out of the very condensed, high-volume pick space.
We have revamped the returns process, as I mentioned just a few minutes ago. We actually do a lot of statistical analysis of returns, look for any outlyers, and then go and fix those outlyers. If it is a partner product or if it is out of our warehouse, we figure out why it has too many returns and we dig into that issue and we fix it for that sku.
For something like a lamp that is getting broken in shipment, we not only say well let’s fix the packaging around that lamp, let’s review how we fix all of our lamp packaging. If we have a partner who has had too many returns, the same kind of complaint, we dig in and we actually take them off the site until we are satisfied that they have fixed that problem, so it has really worked out well in reducing -- I think our returns cost will be coming down significantly too.
Outlook -- I reiterate what I said before. This is really the first three quarters, at the most, of this year. The third quarter is going to look pretty much like the first two. Then we do anticipate hitting the go-fast switch, meaning getting back up to speed in the fourth quarter. We may even hit the go-fast switch a couple of weeks before the end of this quarter, but not enough that it will make a difference to the financial outlook for this quarter.
I am going to talk about our new DRS system. I hope you notice I am less visible in the crusade than I have been in the past. It is not the case that all shareholders want me to be less visible. I feel torn. I have a conflicting set of duties. I would love never to worry about Wall Street again, but I hear from shareholders who buy tens of thousands and hundreds of thousands of shares, and who never get them, who tell me “I am going to stop buying because I do not know what I am paying for.” It is not like it is my job to see that they get what they pay for, I think -- I think that is the government’s job -- but I think I have a fiduciary duty to do something.
So let me explain what we are doing here. If you can see this -- well, if you print these out, you will be able to see them better, but what this is is a simple bird’s eye-view of how share ownership works.
There is Overstock on the left. When we issued shares into the market, they went into a transfer agenda, and I know for most of the people on the phone, if you are Wall Street, you understand this already, but bear with me. There may be some shareholders who do not. We issue our shares and do the [trans-reg], that is computer share. They are injecting them into the system. They go into the DTCC, the banks, the broker dealers are arranged in a hub and spoke system around the DTCC, how the counts at this [inaudible] clearing corporation.
As their clients buy and sell, they just really get moved around among accounts within the DTCC. If you own stock through an account at let’s say Morgan Stanley, let’s call that the bank at the twelve o’clock position, in the circle there, you are a beneficial shareholder. It is owned for your benefit, but it is held in street name, and that is the street name, the bank that you have your account at, so Morgan Stanley actually has those shares at its account within the DTCC.
In the cloud on the left is book name. It is booked in your name. The cloud on the right is street name. The cloud on the left is called registered shareholders, and on the right they are beneficial shareholders.
If you do not object to us knowing who you are, you are a non-objecting beneficial owner, which is called a NOBO, and if you object you are an OBO. So we get NOBO/OBO lists and we can see who some owners are.
Go to slide 17, share certification. This is not a recommendation. It is just an explanation. I run into shareholders all the time who talk about “I tried to get my shares and certificates and take them away from those shorts” and I tell them -- I have never really told people to get their shares and certificates. I am not trying to stick it to the shorts. Shorting is legal and it is fine. I am trying to stick it to people who are counterfeiting, and that is a problem, but people tell me they cannot get their certificates. If you try to get, if you are a beneficial shareholder, and that is the cloud in the upper right, and you try to get your certificate, what you are saying is you are saying to your bank I want my certificate.
Your bank, the guy there at the 12 o’clock position, is sending the message to the DTCC, let’s say it is 1,000 shares, the DTCC then maybe has a 1 million shares, that bank has 1 million shares in its account, they take out 1,000, send that message back to ComputerShare electronically, and then ComputerShare prints up those 1,000 shares and certificates and delivers them to you and that is your -- you become a registered shareholder now.
Now, I hear over and over this is essentially impossible for bigger owners. It is kind of funny. Smaller, retail owners are having more success than big owners. Now, I am not suggesting anybody does this, but if you want to do it, I think you should be able to do it. My shareholders are not able to do it, and I think I am supposed to have some duty to them.
So if you go to slide 18, you will see the solution. Our board has passed, approved our involvement with the Direct Registration System. How this works is a lot like the paper share. You tell your bank I want my shares DRS’d. That message is supposed to be sent electronically to ComputerShare, which then registers your ownership electronically.
So you are issued and sent some e-shares, but it is taken out of that whole system, and it is taken out of all the sloth that is going on within the settlement system. It does mean that you cannot loan them.
I know people are getting 40% or 50% interest to loan their shares, and more power to you. I hear people are actually -- I cannot believe this is true, but I hear people are paying, or I saw something that said people are paying 54% to borrow shares. I hear that to borrow real shares, people are paying $0.06 a day, which is about 120% interest.
I do not know if that is true, but more power to you if you want to loan your shares, but if you do this, you will not be earning your 50% interest anymore. You will, on the other hand, be assured of your ownership.
Now, interesting thing about this is because it is all electronic, it should be able to be done in 24 to 48 hours. There are no excuses. When you try to get paper, I have heard 100 different excuses from shareholders saying my broker told me I cannot -- it is in a DTCC type 1 or type 2 or it is in this or it is lost in the mail, or the sun is rising in the east or anything, but they just do not get their paper. DRS takes all the sloth out of that. They should be able to, in 24 to 48 hours, you should be able to get your shares registered if they bought them.
In fact, if you go to slide 19, there is a statement from the DTCC website that a quick and cost-efficient transfer, if you are interested, just contact your broker.
Now, I suspect what is going to happen is the same thing that is happening to people with paper, and that is you are going to call and say you want to DRS your shares, and your broker is going to make -- well, some people’s brokers who have not been honest, there are most brokers I know are honest, but there are some who apparently are not honest, and when they try to make the same excuses that they make with paper, you will know in this case it is a lie, because they should be able to DRS your shares in 24 to 48 hours.
If they cannot, what that means is that when you sent -- suppose you bought your stock at, keep the math simple, $38 and now it is $18, and let’s say you bought 1,000 shares at $38 and you sent them $38,000, and now it is at $18, if you say DRS my shares and they come back with all the excuses that is what they come back with with paper, what that really means is when you sent your $38,000, they took it, they bought themselves a nice dinner, they bought the wife a present or something, but they did not execute the trade, because if they executed the trade, they can DRS your shares in a day.
What I suspect some people are going to do is then say “Well, wait a second. I thought I just lost $20,000 because it went from $38 to $18, but if I sent you $38,000 and you never executed the trade, just give me my $38,000 back.” I am not advising people to do that, of course but -- my system is hung up a bit -- if you go to slide 20, I am advising you that if you -- I am not even advising you to DRS your shares, but if you DRS your shares, try to, and your broker has come back with some hooey about the same hooey they gave about people trying to get paper, then what that means is they took your money and they never executed the trade.
If you are having any trouble, I suggest you send an e-mail to this guy, Wes Christian, who is standing by to help anybody about who has that problem. I am not telling you how to deal with it.
I have heard from I do not know how many countless dozens of shareholders who say I have bought and bought and bought and nothing is settled and nothing is settled, and I do not know -- well, if you paid your broker money, you should be able to call them and say I want my shares DRS’d tomorrow, and if he cannot do it, if he cannot do it next week, it means somebody is slipping.
I hope that was -- I know that will not be of interest to most people, but I know that there are a lot of shareholders out there who have had problems. I hope that clears it up for you.
Slide 21, finished. Let us go, I believe Jason is on the line. Let us go to questions. Operator?
Your first question is from Aaron Kessler with Piper Jaffray. Please proceed.
Aaron Kessler - Piper Jaffray & Co.
A couple of questions for you. First, when you do hit the go switch later this year to really accelerate revenue growth, how do you maintain the lower sales and marketing costs, or is that possible? Would you expect an up-tick in that cost?
Also, once we start to see this in the technology cost leveling off, they continue to increase here. Is it more of an ’07 or ‘08 event?
Also, once we start to see an improvement in the conversion rates, would you expect to start to see that in Q3 with the rollout of Propeller? Thank you.
Thank you, Aaron. Why don’t you do tech first, David? Because you gave some great data yesterday. Why don’t you talk about when that levels off?
That is a good question. We did a lot of investment in 2005 and we are just really starting to see it flatten. I think for the rest of 2006, you may see it pick up another 10% from where it is now. In 2007, we see it really starting to level off. Depreciation expense is going to start leveling off next year and we anticipate it to maybe be a couple million more than it was this year.
Really, 2007 is when you are going to start seeing the benefit to that.
We really think the second half of this year has a very shallow growth, and then in next year, our goal is to keep things flat, or very close to flat. In fact, I think there may be conceivably a reduction. Then in ’08, you start seeing $35 million of depreciation start rolling out and it starts coming off our books, really starting in the second quarter and by the fourth quarter of ’08, it will all have dropped off.
I was not very surprised yesterday in reviewing it with David how close to flat we are from going from getting from here forward.
On the other issues, sales and marketing, no, you should not see that tick up as a percentage. When I say hit the go-fast switch, it is much more about internal technology and conversion and analytics and it is driven that way, and not by an increase in the marketing numbers as a percentage of revenue.
The third question, conversion, I really think the fourth quarter is when you will see an affect. We are going to turn it on August 10th, but we anticipate six weeks or so. We anticipate years of tuning it in and perfecting it, but I would not expect to see any real improvement this quarter. I am just not counting on it, but I do think that in the fourth quarter, we will have a lot of improvement from the fourth quarter forward.
Your next question is from Scott Devitt with Stifel Nicolaus. Please proceed.
Scott Devitt - Stifel Nicolaus
Let me just start with, are you willing to give out an op-inc number for 3Q like you did for the second quarter?
I think about the same. Maybe a little bit better.
Maybe a little worse. I think it is going to be right in that same range.
Scott Devitt - Stifel Nicolaus
Secondly, your inventory expectations as you head into the fourth quarter, do you expect to build from current levels or not?
Yes, but not as much as past numbers would have predicted. Jason, why don’t you hit that?
We are a retailer. We sell stuff that we hold, so we will definitely -- forever, probably -- as long as we keep growing see inventory peak sometime in the third quarter or early fourth quarter as we anticipate Christmas coming.
However, I think our peak this year will probably be at least 10% or 15% lower than our peak last year, even though we anticipate sales to be up nicely year over year.
Inventory definitely will go up from here, but I do not think it will be any higher than it was last year. In fact, I hope that it will be lower than it was last year.
What we have really learned -- Jason, why don’t you expand as much as you are willing to on what we have learned about inventory? I am not sure how much you want to give away, but…
I have really been focusing on three things. First is the management score, so making sure the customer experiences better and that we do not stumble from the customer’s point of view. I think, although [inaudible] actually in customer service are still doing a lot, and they are implementing a new customer service system to help track customers’ issues, so you will see a lot of improvements there. What we are doing in returns will help customers.
As far as just delivering them their packages, there is not a whole lot more the company needs to do to tighten their systems to make it better. That was the first thing I really was focused on when I came back, and I am not saying I am done, but it is mostly done.
Now, most of my attention is going towards the financial statements and how can we make the financial statements better, and the best way I think we can do that is by controlling our inventory, and the real thing that sticks out as you look at it is the title of what you would call what we were working on is really sku reduction.
There is a big section in the middle that are very good, very profitable sku’s, and they happen to be the stuff we sell the most of. Then there are a whole bunch of other things on the outside that we have done really poorly on over time, so this new Teradata system and the data warehouse is allowing us to look at the data on a real granular level and figure out where our winners are and where our losers are, and we put in a lot of policies and procedures recently in the buying team to make sure that as they place new orders for inventory going forward, especially now as we are starting to look to buy for Christmas, that we are really drawing to the winners of what have been the big winners for us that have had good margins and good velocity.
We are really trying to eliminate and not repurchase items and sku’s in subcategories where we have stumbled that have really put some real drag on our margins.
Another thing we have done as a corollary to this, because we will not be buying in certain categories where we have done poorly, but we do not want the selection for the customer to decrease. We spend a lot of time on the partner program and making sure and implementing on the partner program a scorecard system so that the partners can see how well they are doing, and we are judging them based on how well they perform for our customers.
What we provide our customers with the partner program is we need to make sure that our partners deliver our customers the very best possible service and price. Unless we score them and monitor them and watch them over time, we cannot help our customers by ensuring our partners are giving our customers the best price and product and service.
We have implemented a scorecard system. All of our partners just got that for the first time a couple of weeks ago. They will get it every two weeks. It will help us make sure…
It shows them -- I would not call it judging them so much as showing them where they need to, how well they are satisfying the customers and what they are doing that is creating dissatisfaction.
I think that is fair. It is really a tool for them to figure out exactly, just like Patrick said, where they can help satisfy the customers better. We are going to be doing a lot over -- we have done a lot and we will continue to do a lot over the next couple of quarters to make sure that the inventory we have is the right inventory, not only for the customer but also for Overstock and its financials.
Because of all that, I think you will see inventory not be as high as it normally would.
Scott Devitt - Stifel Nicolaus
Finally, let’s see, fixed operating costs this year, at least in terms of my models, somewhere in the range of 12.5%, a couple of percentage points with that is a non-cash depreciation. On slide 12, your nectar, which I call contribution profit, 6.8% and Patrick said you hope to get it toward 10%, or at least that is when you think things start moving in the right direction.
I am a little unable to get that contribution profit expansion in percentage terms, kind of similarly to the prior question related to how you actually re-accelerate revenue growth without spending more sales in marketing dollars. Also, in terms of even if you were able to get it to 10%, how you can scale the fixed-cost structure so that you can actually turn profitable, because as you are growing at a slower rate, it is a lot more difficult to scale the fixed costs. That is all I have, thank you.
Jason, do you want to say when you think that will be over 10%?
I have not spent a lot of time looking at that number as I have looked at the projections over the next couple of years. I do not know off-hand when that hits 10%.
I think it is over 10% in the first quarter. Was that you saying wow, Jason or was that…? I think that is going to be over 10% in the first quarter.
If it is over 10% in the first quarter, it can do better than that for the year, but I think we are about to see it.
Then, going to the other part of your question, spending 7% of revenue on marketing I think is a good number for now. We should be able to get growth back not by spending higher amounts than that but by doing better.
I guess the common denominator of everything Jason is saying about the inventory and what I am looking at in the customer is you probably all know the [Porato] principal, the economist who found this thing. Statistically you find 80% -- the 20-80 rule, people call it, except in our case, as we look into things, it is not -- the trick has been we did not have the granularity of data to find the 20. We knew that 20% of the product, of the inventory was doing 80% of the benefit, but it was just beyond our -- to find the 20, and our customers, 20% of the customers doing 80% of the benefit, but we now have the systems that can find the 20.
Then you can say let’s eliminate all the costs associated with the other 80% that is only giving you 20% of the benefit. In fact, the truth is, as we get into the data now, we see it was not 20% giving us 80%, it may have been 10% giving us 80%.
It is really opening our eyes about our business to be able to get the resolution we are getting now.
I think what all that means, Scott, is the way that gets over 10% in the near-term is there has to be a quick increase in margin expansion, and margin expansion can come definitely from selling more of the 20 that does the 80, and less of the 80 that does not do so much gross margin for us.
If our product mix does not really change that much, because remember, 80% of the sales is coming from this small 20, but we are able to eliminate the 80% of the stuff that does not sell that much but has a drag on margin, it could actually increase our margins dramatically, even though the product mix itself would not change that much.
I think, Patrick, what you are saying is it can get over 10% in several ways, but one of the big key ways obviously is your margins increase.
Scott Devitt - Stifel Nicolaus
Scott, hold me to that. Remind me in the first quarter of my commitment to get that over 10% by the first quarter.
Scott Devitt - Stifel Nicolaus
I will write it down right now, thank you.
And ask me if I enjoyed my [stay].
Your next question is from Bill Lennan with Wedbush Morgan.
William Lennan - Wedbush Morgan Securities, Inc.
Talk about gross margin first, 40 basis point improvement sequentially, so could you give us an idea of how much of that was mix, say BM/BG falling out, or organic improvement?
Then, in the prepared remarks, you talk about a drag on gross margin for the rest of the year, Patrick. I wonder if you could kind of frame that for us and help us understand how to be modeling gross margin.
Then, generally, I also wanted to hear a discussion if you could on Q4. I think you said earlier, you talked about a shallow revenue growth for the second-half of the year. I know you have already addressed Q3 specifically, but I wonder if you can just give us some thoughts on Q4 as to growth levels and where you think profitability will come in, at least a ballpark figure? Thank you.
Gross margins, Jason, people can back in to what the gross margin is in our direct versus partner, can they not?
Yes. I guess just generally, two things really happen I think in gross margin. You see a 40 basis point improvement, but the truth is operationally, there was much, much more improvement than that. At the same time, we are getting rid of some of the inventory from last year that is moving slower, and we are doing a lot of tests on some velocity of some of our inventory.
Net net, it went up 40 basis points but what you really see is operationally, we got a lot better at some stuff and then the cost of some of the actual merchandising margin, or the cost of the product actually went up during the quarter.
Those two things together netted to only a 40-basis point improvement.
Can I tack a footnote on there? I would say, since people can back into it anyway, that our partner margins are running on a GAAP basis, Jason, can they -- I do not want to give something away that is not in there, but can they --
No, it is in there.
So it is what, 18% or 19%?
It is just over 17%.
Okay, and on our core, on a GAAP basis, is what? 10.5%?
So that is why you are seeing the 14.4%. A few additional comments -- that 10.5% is really a combination of some stuff that is over partner, in fact some stuff that is over 20. Secondly, a bunch of crud that we are clearing up.
How we got that crud is -- I should not say crud, but it is financially crud and that is why the margin is where that is.
Last year, when we were still growing 100%, we got too hungry and I think we lost our discipline buying. We went out and bought too aggressively and did not get deals that should have -- that met our normal standards. We were just trying not to choke off growth, which has happened to us on one or two occasions. There was a Christmas we had that was a great Christmas, and we certainly hit the skids the next quarter because we had nothing left in the warehouse.
We probably, nine months ago going into Christmas, just lost some of our discipline. So there is cleaning that up, but what is different this time is we actually have a great view, not just into the buyer level or the store level or the department level, but the category, sub-category, and right down to the sku level of where the real returns are.
It is just something we could never have done under our old system. I mean, Teradata gives us stuff at a push-button that would have been weeks and weeks of work with Excel sheets the way we were doing things before.
The idea is really just to sell through that stuff that and not replace it and just keep the stuff that is over 20%, and keep replacing that.
I think clearly core margins should be higher than partner margins, so that is why I think that once we sell through the stuff, you will see a real release, the bow string will be released, and a real surge in gross margin.
However, I think it is going to take us through the rest of this year to work our way out of those inventory positions. Once we work out, I think you will see a dramatic increase.
As far as the operation costs, there is probably I think another 150 basis points that we can, maybe 200, but at least 150 basis points that we can now improve on our current set of systems. Our new customer service app is going live Wednesday. Our new warehouse mezzanine -- If I do the math, we should gain 150 basis points in margins from that, but again, that is going to be -- I do not know how much that is going to be offset, but that is going to be offset by moving out of $20 million or $30 million of inventory that we can easily, we can comfortably move out of by the end of the year.
That is why I think you will probably see in the fourth quarter, I think the margins will stay about where they are this quarter and tick-up in the fourth quarter, but then we will be, we will be able to operate both with lower margin, we will have turned some things into cash -- I mean, with a lower inventory higher turn and we will have released some cash.
As far as the fourth quarter, I do expect profitability. Jason, do you want to say…?
No, it really just depends too much on the last of this. We really want to have any slow-moving inventory out. We just do not know yet, I do not think, how much, how easily and how quick that stuff is going to be selling.
You have seen there is a drag on margins in the first and second quarter from selling this stuff. So far, it has sold okay. We are getting rid of it and it does not look like we have -- obviously, we are more than adequately reserved, I think, for all of it, but just as far as having sold the last of it, so that there is no more drag on margins, we definitely want to have that happen by the end of the year. Getting rid of the very last of it, I just do not know at what price it is going to clear, so…
I am looking for profitability, and if we do get some lift from all the testing and analytics, maybe we will have some meaningful profitability, which would be -- to me, anything over $10 million I would say is great and meaningful and so forth, but I do want to see at least profitability in the millions.
Your next question comes from Frank Gristina with Avondale Partners.
Frank Gristina - Avondale Partners
Thank you. Patrick, you mentioned returns in your comments. I was just curious if we could do the same analysis. If returns were X, for the December and March quarter, what are they down in the June quarter, if you reduce those aggravation points to the 20,000 range in March. Do you see an impact in returns as a percent of sales?
Then, put an edge on that, maybe by expressing how much gross margin impact -- I guess a large return was having on your gross margin.
Okay. I will take part of that. The return project, which we call Project Boomerang, has been wrapped up and it is a project that said let’s take items that are having a statistical disproportionate share of returns, take them off the site and fix them if they are coming out of our warehouse, or call our partner and say hey, this product is getting returned too much for this reason and let’s address it, and we do not put it back up on the site until it gets resolved.
The discretion is taken away from the buyer and it is actually given to this Project Boomerang team, which now sits with our customer care group. So they are the ones who actually, it has to be fixed to their satisfaction before it gets put back on the site.
That really came live in June, so I do not know what -- I do not know what effect it would have had on the second quarter, but I do know that the projects we have done -- the sku’s we have done that with, we now have a couple of months of experience, are experiencing a 50% reduction in their returns.
It is a business process. It did not cost us any money, but it is -- now, overall, first of all, because it came live around June 1st, I do not know how to quantify its effect in the second quarter. Dave Chidester, do you want to chime in on that, or how you would quantify this effect going forward?
I think we have been making efforts all year, that project just gotten implemented, but we have seen overall a slight decrease, probably 50 to 100 basis point decrease in our return rate this year. It is hard to extrapolate exactly what it is going to be going forward from a quarter’s data, but we have seen it come down a little bit.
I think clearly if we take sku’s that have high return rates and fix them, that is going to have a positive effect on our overall return rate.
I should have just thought of it that way, yes. I do know that our return rate, our quantities of returns that we have to process is down significantly from where it would have been the same -- if we had run it the same rate last year. I did see that data a few weeks ago. Even that is not too meaningful yet, because it really has only been two months of the year that this new system has been in place and working.
I would say, I do not know if we release what our -- we look at the net cost of returns, which is a function of how much comes back and how much we can re-package and put up on the site again and sell versus how much we have to liquidate, et cetera. That comes out to I would say a total cost of -- we have about a 6% to 8% return rate. The actual net cost of returns -- and also, I left out you factor in the cost of handling the returns and then less how much we can recoup from customers who have destroyed things and such, it is less than 6% to 8%. It is a single-digit number.
I think you can expect us to reduce that number by about a quarter, about 25%. Again, that goes straight into margin improvement.
Frank Gristina - Avondale Partners
Great. One last question -- I noticed your sales growth was 6% plus, but your direct sales grew 14%? I imagine this is a headwind on your gross margins, until you can get some scale, but is this a deliberate step, or is it just seasonality between partner and direct? Because I would assume that going forward, if all these things are implemented, you have much better margin control on the products that you ship out directly. Was this a deliberate focus, or was it perhaps part of the very good prices on the inventory that you are flushing out?
Jason, why don’t you…
The latter. You hit it right on. The latter. It was not intentional at all. It is just a function of customers are smart and they find out where the best prices are. If we have too much of something and we lower the price, then sales in that particular item increase. So you are exactly right.
Frank Gristina - Avondale Partners
So going forward, you are still not ready to try to merchandise your website to push the products that you are carrying? It is going to be that same 60-40 mix?
Yes, we are set so we can do that, and because we run into a situation at Christmas where if we have partners or one of our own warehouses that falls behind, we want to be able to actually ratchet down sales to that partner or own warehouse, so we do have the systems that let us do that.
We do that until somebody catches up, if somebody falls behind in shipping. So by doing things like placing it in a less -- a product gets lower position in a sub-category, it will drop sales.
We are wired to do that, but that is now what has driven this. What were we, 49% in direct in last quarter? That is just based on organic pricing that Jason controls, an [overt] decision.
Frank Gristina - Avondale Partners
We have time for one more question.
Certainly, sir. Your final question will be from Shawn Milne with Friedman, Billings, Ramsey.
Shawn Milne - Friedman, Billings, Ramsey Group, Inc.
A couple of questions. You talked a little bit about your tech spending leveling out. Maybe this is for David. If you were to look out into ’07, if you get the fix not put together between G&A and tech spending, what do you think for a number in ’07? Maybe 110 to 120? Or can you do a little better than that?
Secondly, Patrick, that is a pretty ambitious target. I think you actually just talked about your goal -- I mean, if you are going to get to 10% contribution margin, it sounds like you are betting on, obviously, that it has kind of come from the gross margin side.
I am looking at my model here, Patrick, and it looks like your best direct gross margin ever for the company was about 13%, 14%, so it sounds like you are -- again, it sounds like you are betting on a lot of room for improvement on inventory turn. Thank you.
Jason, what were you saying?
I think he is saying he wants a piece of my bet.
I think you will see -- just mark me down for 10% contribution margin in the first quarter.
Your question about tech and G&A, a range of 110 to 120, I think that is reasonable. We are tracking to be somewhere right in the middle of that this year. I think our goal -- that is a tough goal to hit, but that is our goal, to be in that same range next year. So 120 is probably a good target for us next year.
We talked of the possibility of keeping things flat next year, except, David, we have to have some increase in depreciation next year, right?
It will be $2 million or $3 million more, yes, is what we are projecting now.
$2 million more?
$2 million to $3 million, yes.
Yes, so there will be that increase, but other than that, I think we are going to be able to keep G&A pretty flat, and tech, you know, tech developers and the non-depreciation pretty flat. Then again, in ’08, a whole bunch just starts washing out.
In fact, I think we are aiming for zero -- it may be a little ambitious, but we are going to see if we can come up with a plan that gets us zero growth in G&A and tech spending outside of depreciation.
Shawn Milne - Friedman, Billings, Ramsey Group, Inc.
Patrick, while I have you, any thoughts on what is your perception of e-Bay Express, and are you just keeping a close eye on it? Thank you.
My perception is it is very good. I think it is a good program. I am not keeping as close an eye as I should on it, but I think it is -- I mean, I have tried to be -- I feel like anything I say gets exaggerated and twisted these days by certain folk, but I am just trying to give my honest feedback. People asked me about Amazon Prime, and I said I did not see the sales proposition there.
I think e-Bay Express is a very good progam.
I also would suggest keeping your eye on, and this is out in the public now, the whole Google. You know about what is going on there. I think that -- I have read one or two articles, so I do not want to get into trouble by saying too much, but I think that is going to be a pretty good competitive program.
So nobody believes my 10% contribution margin?
Well, you do the math and our margins have to expand quite a bit to get there. I know we think it is possible and I know it can happen -- having it happen in the first quarter, as much as it has to expand to get to 10%, it would be fantastic if we get there.
We have pulled the bow string very, very tight and we are releasing the bow string in about eight weeks. I think it will be there in the first quarter.
Are there any other people waiting to ask a question, Operator?
No further questions at this time, sir.
Great, I will wrap up.
It just occurred to me to comment on something -- I hate commenting on this, and I am going to comment on it just enough to say that I think in the future, we are going to -- we ought to have -- there is some rumor going around on the message boards and people are contacting me about a buyout, and somebody has posted a buyout offer on the net. I am mentioning this only to say I believe this is a hoax. I have strong doubts about this. I of course have to not treat anything as a hoax, but nobody should contact me asking me about this anymore. I believe it is a hoax.
In the future, I am now announcing I am not going to comment on anything like that that comes out, any rumors or things like that.
Jason, did you have anything else you wanted to say about that, or anything?
Not about that, no. It feels good to be back. I think we are both back, both really engaged in the business. You are working on internal marketing and trying to get conversion rates up and I am working on inventory and making sure we have the right stuff and really trying to drive our margins up. Hopefully we are both successful and you will see some real results in the coming quarters.
It feels -- I think that both of us took a bit of a step back in time, because in the early days of this company, Jason and I did just about every job in the place -- separately, but we worked, we switched executive hats all the time and ran different things. That is kind of what is happening here, where Jason has stepped back in and taken -- so much data is coming out of these new systems that we need someone like Jason to actually be able to make use of all of that.
I am so excited about -- I know that I have been -- the one thing the miscreants say, the [blaggards] say that has improved, despite it has been a distraction, it is not like I woke up one day and said “I want to go get in a fight with the most powerful people in the world” but I felt I had to.
You know, there is a new suit by Fairfax Financial, and if you take the time to read that 89-page suit, it reads like a John Grisham novel, and you should read it. If you want to have an idea about what has gone on with us, you can just read that. I mean, there is so much that has not gotten public yet about us, but you can read that suit, and it is a good picture of the kind of stuff we have been fighting. Maybe it will make my actions a little bit more not that explicable to people, but I am very excited to be back with an executive hat on, running something within the company. It is an area, to be honest, that has been gnawing at me for several years, and I am excited to be engaged with it.
And it is great to have my partner back.
Okay, we look forward to talking to people in three months. Again, expect basically more of the same this quarter. I am sorry it is going to take -- this is going to turn out to be a one-year mulligan where I screwed up and I let us come off the rails and it is going to take us a year to get everything back on the rails, but I think we will be just fine.
Thank you for your participation in today’s conference. This concludes the call and you may now disconnect. Have a good day.
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