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Overstock.com, Inc. (NASDAQ:OSTK)

Q4 2006 Earnings Call

February 5, 2007 11:00 am ET

Executives

David K. Chidester - Vice President-Finance

Patrick M. Byrne - Chairman of the Board, Chief Executive Officer

Jason C. Lindsey - President, Chief Operating Officer, Director

Jonathan E. Johnson - Vice President, Corporate Affairs and Legal, Secretary

Analysts

Aaron Kessler - Piper Jaffray

Justin Post - Merrill Lynch

William Lennan - First Albany

Scott Devitt - Stifel Nicolaus

TRANSCRIPT SPONSOR
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Operator

Good day, ladies and gentlemen, and welcome to the Overstock.com, Inc. fourth quarter 2006 earnings conference call. My name is Tanya and I will be your coordinator for today. At this time, all participants are in listen-only mode. We will conduct a question-and-answer session towards the end of this conference. (Operator Instructions) As a reminder, this conference is being recorded for replay purposes.

I would now like to turn the call over to your host for today’s call, Mr. David Chidester, Senior Vice President of Finance. Please proceed.

David K. Chidester

Thank you. Good morning and welcome to Overstock.com’s fourth quarter 2006 conference call. Joining me on the call today is Dr. Patrick Byrne, Chairman and CEO; and Jason Lindsey, President and Chief Operating Officer. Before I turn to the financial results, please keep in mind that the following discussion and the responses to your questions reflect management’s views as of today, February 5, 2007 only. As you listen to today’s call, I encourage you to have our press release in front of you, since our financial results, detailed commentary and the CEO’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 27-A of the Securities Act of 1933 and Section 21-E 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 material 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 10-K, 10-Q, 8-K, and S-1.

I will now review the financial results for the quarter and year ending December 31, 2006. Please note that all comparisons will be against our results from the fourth quarter and full year 2005, unless otherwise stated.

Total revenue for the quarter was $297 million, down 6%. For the year, we had total revenue of $796 million, down 1%.

Gross margins in the fourth quarter were 10.3%, down from 14.6% last year. For the full year, gross margins were 12.8%, down from 15% in 2005.

Total operating expenses were $71 million during the quarter and $197 million for the year, an increase of 36%, and as a percent of sales, this equates to just under 25%, up from 18% last year.

Sales and marketing expenses were down 9% for the year to $73 million. However, G&A costs increased 49% to $54 million and technology costs grew 150% to $70 million. I will note that included in our fourth quarter technology and G&A costs is approximately $6 million related to the early termination of a co-location data center lease and the accelerated depreciation of other facilities-related assets. This is one of the first big steps we have taken to reduce our tech and G&A expenses going forward.

Our net loss was $41 million for the quarter, or $1.92 per share, compared to a net loss of $6 million last year, or $0.33 per share. For the year, our net loss was $97 million, which equates to 12% of revenue and a $4.77 loss per share.

We ended the year with $128 million in cash and cash equivalents. This includes $40 million that we raised in December through a private common stock offering. We had positive operating cash flow of $54 million in the fourth quarter, bringing us to a negative $25 million operating cash flow for the year.

With that, I will turn the call over to Patrick.

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Patrick M. Byrne

Thank you, Dave. Well, Q4 was the end of a washout year of 2006. I am going to give more color than I have given before and we’ve talked about, or I’ve talked about systems famously, the systems problem, and there’s lots of things that have gone on here but there is really a set of issues that are deeper than the systems issues that -- well, like I said, I feel I owe you more color as owners. Now, whenever I try to give folks more color as to what is going on, even though I will say look, this is all my fault, I take responsibility, I’m not making excuses, and I try to explain what I have done wrong, that always somehow -- the bad guys always transform that into “Oh, Byrne’s making excuses.” I’m not making excuses. Once again, I am taking total responsibility for this.

But as owners, I think that you are due more color, perhaps, of what has really gone on.

2004, we did $500 million. In that time, or up until that point, I would say that our infrastructure and our expense structure chased our revenue the whole way up. We thought we were okay all those years but in many ways we, as -- well, put it this way, when outside people came in, they would look at us and say you guys are operating on a ridiculous shoestring and without -- inappropriately, and certain Sarbanes-Oxley started making us think harder about how much of a shoestring, how thin a shoestring we wanted to be operating on.

Another thing is if you asked us at the end of 2004, when we had just done $500 million, what the next couple of years looked like, for all we knew, we were going to be doing $1 billion, $2 billion. Now, it may seem odd that we would not know, really have any idea what our next couple of years of revenue were going to be, except remember in the previous four years, we had grown from $2 million to $500 million, so there was no real way for us to know what was going to be, what our revenue was going to be.

And as a consequence, we decided to build out our infrastructure and our expense structure and to get -- I think there was a period in early 2005 where we were starting to realize that if that wall we had skimmed through previous Christmases and holiday seasons, sometimes run’em-and-gun’em, sometimes with neat tricks and on a shoestring, that if we really did continue to have those kinds of growth rates, we’d hit $1 billion, $1.5 billion, $2 billion. We were really playing with fire.

So we built out our infrastructure, as has been much discussed. We have discussed less the fact that we built out our expense structure to support a company that continued along those lines. We built out our expense structure in the sense of we moved to a much bigger building, from 36,000 feet to 130,000 feet.

We over-built a new IT co-location facility. We built a huge facility, probably much more than we really needed. We really expanded our staff. The staff expansion also came as a result of the computer problems. There was a period where we actually just about doubled the size of our merchandising staff, just because there had to be all kinds of people processing PO’s and doing things by hand instead of, or manually in some sense versus what we had before.

I would also say that in some sense, I lost the discipline that I had for the first several years of the company. Lost the discipline that had really been part of us operating on a shoestring, and we did consciously say it’s time to get ahead and it’s time to kind of pad things. We were just -- well, then the meltdown comes and 2006 was really a year of getting things back under control.

First of all, the infrastructure, and the infrastructure is under control and is tuned and is beautiful, but we are not done. The expense structure is still -- we built the expense structure for a $2 billion company and we got stuck here. We have had to fix our expense structure and we are not finished with those fixes.

We have fixed some things, and we have fixed them better than they ever were before, as you are going to see. Our capital management is superb, and we developed a system for bringing discipline and capital allocation of the buyers. Jason has taken that over with a really superb team of several people he’s built under me, and the discipline in capital allocation is superb.

Customer service, it’s not all the way there yet, but as you saw I think in November or so, we got selected by American Express and National Retail Federation as the number four ranked customer service in the country. We were not in the top 100 or 150 the previous year. That was Stormy. She took it over and she is not happy with it yet. She wants to be number one.

So it’s made a lot of progress and it has a ways -- she still sees grounds for areas of improvement, but it did -- we do, I would say we got that pretty well fixed to be number four. Again, her goal is to get it to number one this year.

Logistics: Steve Tryon is over and our logistics have just gotten drum tight, both in terms of shipping the right things, shipping everything promptly. Our handling costs are now just drum-tight, lower than they have ever been.

Our margins, you are going to -- yes, they were lousy now in the fourth quarter and for the year. Part of that comes with the reduction -- remember we were operating at about the same size a year ago and we had almost $100 million of inventory. We now have -- we started the year with $20 million of inventory, and that is not affecting us -- we are not losing a step. In other words, the $20 million is as good and can support as much sales as the $95 million, $93 million I think at the end of the previous year.

There are some things that are not fixed yet. The marketing partially is. We have developed a team. We have hired a superb fellow. He was chief marketing officer of a large credit card company. I have been for five months running a group, actually building a group that we call internal marketing. It is a function we’ve always had but not really focused on and we have built it into a real department -- solid people with experience there and you see a lot of changes going on in our web design, website. We also have some outsource relationships where we’ve picked up virtual marketing experts and a few other companies who are supporting us. You see recommendations, pretty good recommendations now on our site and a lot of site design evolutions. If you watch our site, you will be seeing -- you are seeing changes week by week.

But our expense structure is still inappropriate for a company of this size, and what we have to do now, having gone from one end, operating on a shoestring, to suddenly padding it up in preparation for what if we did hit $1 billion, $2 billion, we have to shed some of that expense structure. We have already shed the staff that was overbuilt, where we had to shed staff. But there is more. There are other expenses in rent and systems and such that we are right-sizing to our current size business.

So with that as an introduction, we are going to hit the slides.

Slide 2 is a repeat of what Dave Chidester said.

Slide 3, here’s conversion, and there is more of a pattern here than might be at first apparent. If you take a look, it sort of bottomed out, originally it bottomed out in August. What the slide shows is how are we doing conversion this year versus the previous year -- I’m sorry, 2006 versus 2005. What really happened is it started really degrading half-way, dramatically half-way through the year. We thought we had it turned around. We thought we had it turned -- well, we did have it turned around in August and from August up through the end of November, you see with a few spikes against us. This is week by week, the conversion rate of ’05 minus the conversion rate -- actually, the conversion rate of ’06 minus the conversion rate of ’05.

You see from August up through November, we thought we -- well, we did have it fixed and it was improving. What happened in December is interesting. What that is is we had a big influx of traffic. That is the traffic that we have gotten that we have been the worst at converting, and I will leave it to your imagination what kind of traffic that is in December. So we had this big swing against us as this big segment shift came. But of course, we really isolated where we need to improve and it is that segment of traffic which suddenly swelled and moved against us.

If you go to slide 4, you actually see not quite so clear a pattern, but the same basic idea. We had up through by the end of November, I think we had it fixed. We have that big slug of traffic coming in in December that is our worst -- that we have been the worst at handling. It has bounced back right after the holiday season was over. You can just see it bounced back a bit.

So again, we know where the -- we had fixed between slides 3 and 4 I think we had fixed the conversion problem in most of our traffic, but there is a big slug we had not and that’s the big slug that hit just in the holiday season.

Moving to slide 5, Jason, are you on?

Jason C. Lindsey

Yes, I’m here.

Patrick M. Byrne

Why don’t we share these slides? Go to slide 6, folks. Jason, why don’t you talk about this?

Jason C. Lindsey

Slide 6?

Patrick M. Byrne

Slide 6, inventory turns.

Jason C. Lindsey

Did you skip slide 4 and 5?

Patrick M. Byrne

No, I did them.

Jason C. Lindsey

Okay, well, I wanted to say a couple more things on slide 5.

Patrick M. Byrne

Go ahead. Back to slide 5, go ahead.

Jason C. Lindsey

Well, the operation, we have given you many updates in the past about operations and we have talked about our aggravation points. I don’t want to get too much into that. I just want to tell you that that group still meets. We’ve divided our order process flow into 17 different steps and we have scored each one of the steps on how aggravated you would be as a customer. We continue to meet and that number of the aggravation scores continued to drop, and it’s better than it’s ever been and it’s improved again almost every month as we go by.

But we are still seeing improvements there and I don’t think there is much to gain at this point, because we are approaching a zero, or as good as you can get, so --

Patrick M. Byrne

In fact, Jason is being modest. If we actually had just stuck with our original way of measuring, we went from 5 million to probably under 1,000 or under 500 aggravation points. However, in the course of fixing all these little leaks and all these little issues, we turn up new ones and we keep adding those to the score, but it still is a score that is in the four-digits. But on the original yardstick, Jason --

Jason C. Lindsey

It would be negative, I think, because we have turned so many things of points that did not even exist as points before, so it has gotten much better.

The second point on this slide is inventory control and gross margins. I don’t know if you can see from the press release but our inventory balance has gone from about $100 million this time last year to about -- or excuse me, at year-end, to about $20 million at year-end. So our inventory on roughly the same amount of sales, that means we have gotten five times better at turning our inventory.

All of the things we have talked about before as far as classifying all of our SKUs as either red and green and 80% of our -- excuse me, 20% of our inventory was doing 80% of our gross profits, or even more than that. We took all that to heart in the fourth quarter and although the fourth quarter results are very bad, and I admit they are very bad, they were bad on purpose. In other words, we used the fourth quarter to get rid of all the slow-moving inventory. I am quite pleased with the inventory balances we have now.

All the study that went into the red and green and was this really going to work, it sure seemed like theoretically it was going to work, but I am pleased that the fourth quarter is now over. We have sold it. Our inventory turns are much higher. Our margins are much higher and it really does feel like we have made a lot of progress there.

Patrick M. Byrne

We sucked a lot of cash back out of the system.

Jason C. Lindsey

Yes, and the other thing I am excited about is we talked about for years that our margins, our margins for our direct business, meaning the business where we actually touch and warehouse the inventory, theoretically should definitely be higher than our partner business because we have a whole bunch of extra expenses because of that, and we are taking capital risk, et cetera. But for some reason, we never really seemed to get there. I am quite encouraged that in ’07, I do believe that our direct margins will be higher than our partner margins, which is where we should have been all along. In other words, if we touch it, there should be a few hundred extra basis points as a reward for having gotten our hands dirty. And I think you will see that in ’07.

Then, as far as cost cutting, I do think you did a pretty good job of, Patrick, explaining what is going on there. There is some --

Patrick M. Byrne

Why don’t you give your own color to it?

Jason C. Lindsey

Well, I think there are a lot of things that need to get reduced. Some of that process has begun. You will see it much more in ’07. A couple of the real big ones are like you mentioned, rent. We are in a very nice part of town. Our entire building here, our headquarters, just recently all went on the market, so we plan on moving as soon as we can lease this building out into our warehouse.

Since we have excess warehouse space now that our inventory has shrunk so dramatically, there will be no incremental rent for moving into our warehouse. The cost to build that space out will be very minor, meaning several months rent here at our corporate facility. So I think the break-even, the economic decision is very easy. It makes sense for us to move over there.

Another place where you see just way too many expenses is in IT. I think if you look at our ’04 IT costs versus our ’06 IT costs, you can see that they are 4X as a percentage of sales what they used to be. Part of that is ’04, we were on a shoestring and we were probably spending too little, but in ’06, we are clearly spending too much for the size of business that we have.

I think you will see our IT costs drop dramatically during the year and we will remove as many of those costs as we possibly can without putting in jeopardy the business.

Patrick M. Byrne

Although some of those, before you get off IT, some of those, a lot of that IT cost is depreciation.

Jason C. Lindsey

Yes, I was just about to say in ’08, just over $10 million of expenses will drop off that are depreciation and the depreciation, there’s nothing we can do about that other than, you know, we have written a few assets off that you have seen in ’07.

Patrick M. Byrne

Although a fair bit of -- I don’t know if you want to quantify it, but a fair bit of what went on in ’04 was also taking charges related to these kinds of events, cost-cutting events, not so much writing down of, writing off of equipment, but restructuring our rents and things like that.

Jason C. Lindsey

Yes, well, I think the way to look at depreciation is my guess is that in ’08, you will see depreciation go down something close to $10 million, plus or minus a couple million dollars. I do not anticipate a lot of new capital expense this year, although there will be some. So I think net net, I would expect in ’08 about $8 million to $10 million of depreciation expense to come out of our expense structure.

Patrick M. Byrne

And how about rent? Do you want to say what you -- on the rent?

Jason C. Lindsey

Well, I know that you will see at least three, because you have seen in December, we reached an agreement with our landlord for that new co-lo facility, so three will come out. If you look at additional rent, I think there is another -- depending on the success of renting out our new buildings and what we can get for them, I hope that there is more than 10 more to come out.

Patrick M. Byrne

Yes, that sounds right.

Jason C. Lindsey

Which is a big number for our business. I’m sorry, you were on slide 6, Patrick.

Patrick M. Byrne

Sure. Go ahead. I thought that you wanted to talk about slide 6.

Jason C. Lindsey

I don’t know that we have a lot left to talk about on slide 6. You can see that we have gotten much more efficient. Our inventory turns have gone up dramatically.

Patrick M. Byrne

Now, is that turn number calculated on the average inventory for the quarter or the ending inventory?

Jason C. Lindsey

David.

David K. Chidester

Average inventory.

Patrick M. Byrne

Yes, so you are actually going to see that move up again quite a notch from there. I think that you will see that over 20 right away.

Jason C. Lindsey

Yes, I think we have made a lot of progress there and I think that it will be evident over the coming quarters.

Patrick M. Byrne

Yes, well, okay.

Jason C. Lindsey

Slide 7, Patrick.

Patrick M. Byrne

This is a big one. This is the net promoter score we have been reporting for about a year, since we started tracking it. This comes out of that Fred Reichheld book I’ve mentioned several times, The Ultimate Question. For comparison, I will remind you that in that book, our score is now at an all-time high, 70%. By comparison, I think the average company in America he says in that book scores like an 8, and the superstars score 35 to 70. He has about 20 superstars listed in that book. Well, our score is at the highest end of that. We really have fanatic customers.

What we have realized though is, and this is in part due to this, we really have a very senior guy out of, as I had said, he had been a chief marketing officer at a large credit card company, wonderful fellow, and he has joined us full-time. He is gradually, I’m sort of -- we are pilot/co-pilot on internal marketing now, and I am peeling off over the next month or two, but he has already built a nice analytics group and is finding some very interesting things.

One is there is one aspect of customer behavior that turned out to drive an awful lot for us and to drive our growth. I am not going to say exactly what it is but it is one particular event in customer -- say migration, migrating from people who are just giving you a try to people who become hardcore, die-hard Overstock fans. That event, if you graphed how people were behaving along that dimension, it basically looks like this chart on page 7 only shifted to the right a good six to nine months.

So it’s kind of as though the NPS score drove -- the collapse in our NPS score, this net promoter score, how happy we were making customers, and here is just shows it getting down to 37, but the truth is I think that we were eating up a lot of good will. 37 still is much better than the average company but we were just -- I think when we dropped at 37 back in ’05 because we had so much good will built up, if you graph this other aspect of behavior, it is this graft just shifted to the right six months, so it looks -- actually, it is a little bit more than six months.

So it looks like that this customer, this NPS score drives this other trigger in customer behavior and then that trigger in customer behavior drives growth. And that’s the chain which makes us optimistic that as the months roll by, we will see a return to certainly not the levels of hyper-growth before. I can’t imagine, but --

Anything else you want to say on this, Jason?

Jason C. Lindsey

No.

Patrick M. Byrne

I will say this is a combination not just of customer service, although the customer service team has been organized and gotten trained and there is discipline in a fantastic way, but this is also a reflection of all kinds of other things we are doing, from the products we are buying to the timeliness with which we and our partners are shipping them.

We have just now gotten so we can measure -- well, over 2006 we got so we could measure so many little details of our business and we look at all these aspects of our business and how they relate to net promoter score at the individual customer level, so when we see a type of product or a type of -- or a group of customer service agents who when consumers interact with them, are giving us lower NPS scores than they should, that is what we are using to isolate our problems. It’s really been a powerful metric for us.

Slide 8. This is auctions, and I will just mention this because this is the sell-through rate. In fact -- Jason, was that a comment?

Jason C. Lindsey

I have a head cold.

Patrick M. Byrne

Okay, sorry. Well, as you can see, our sell-through rate was in the low-single digits. For comparison, I believe e-bay is 27% or 28% on the way we measure, using the yardstick that we use to measure sell-through rate. There are different ways, but apples-to-apples I believe they are 27%, 28%.

We made a lot of changes in the fourth quarter and I have mentioned that two years ago, it lost over $5 million. Last year, it lost a little bit over $1 million. This year, it is already profitable. It has been profitable since December. It suddenly is catching fire, at least in the sense of sell-through rate.

We have cut the expenses out of it dramatically and in fact, there are -- we had a day at 31% a few days ago, 31%. It is the first day we have been higher than our understanding of what the e-bay sell-through rate is. The people who are selling -- I mean, we can go into why -- this isn’t material in the sense of it is really going to be able to affect our income this year, but this, you can see this dramatic change is something. We finally got the right combination of oxygen and nitrogen into the heart here, and it is glowing.

Let’s go to page 9, questions. I have a couple of questions that had come in.

Let me start. Jonathan, can you take the phone? Are you anywhere around?

Jason C. Lindsey

Yes, he is right here next to me. Can I just make a comment about the estimates before we go to Q&A?

Patrick M. Byrne

Sure.

Jason C. Lindsey

I had Dave print this out for me this morning, and I have an advantage over you, Patrick. I have seen what the consistent estimate, or the analysts’ consensus for us for 2007 is, and I know many of the analysts have models and it’s a difficult spot that they are in because they are trying to update their models without guidance. I just want to make a couple of comments, because maybe it will help the Q&A.

You have us for the year at a 5% growth rate and 8.5% of sales on marketing. When I look at that, and you have operating income of $60 million, more than a $60 million loss, although in total I think your numbers seem reasonable and I am okay with all of them, I do think that we get there a slightly different way.

We are really trying this year to spend less marketing as a percentage of sales, and so I think you will see as we go through the year, we will not spend 8% of our sales, or excuse me, 9% you have on marketing. I think it will be less than that. I think our --

Patrick M. Byrne

We are already below that, actually, aren’t we?

Jason C. Lindsey

Yes, so I have looked at your numbers. They all seem reasonable. I am okay with the totals but I think we get there a slightly different way. I think we spend less on marketing and you have to adjust your sales growth down accordingly.

Did you want me to get Jonathan on the phone here? I am going to have to go to the speaker phone, so hopefully the noise --

Patrick M. Byrne

Sure, just ask him to put his mouth close to the mic.

Jonathan E. Johnson

You still there?

Patrick M. Byrne

Yes. Actually, before we go to Jonathan, I want to make one more comment on what you said. We, five or six years ago, considered co-locating in our warehouse and it’s one of our biggest mistakes, I think, that we didn’t. My bad. But like five or six years ago when we outgrew our first facility and we went into a second shoestring facility, we thought then moving into the warehouse, which is about 15 miles away, and at the time, we had so few people and it would have inconvenienced a lot of people. We actually had one whole department tell us you will basically lose most of us if you do it. But we should have just gone to the warehouse.

I have been in companies, catalogue companies which run out of their warehouse, have their office space in the warehouse. We are -- well, at least Jason and I, are so excited about building a nice office over in the warehouse. There is -- a fair bit of the internal friction in the company comes from all the coordination from the buyers and the copy editors and the guys taking the photo and stuff and the logistics and the managing of samples back and forth. So I’m excited to be over there.

Jason, do you have any comment on that?

Jason C. Lindsey

No, I think -- I agree it was a mistake in the past. We should have told that entire department, all three of them, that you have to just live with it. I think it is going to be great for business. It will be fantastic for our expense structure and it is going to feel like old days.

Patrick M. Byrne

Yes, and when you gave those -- we know $3 million we are cutting out of rent and it could be another 10, that is versus our normalized expense structure, not the expense structure we showed in 2006, which includes a fair bit of restructuring charge.

Jason C. Lindsey

Yes, I think it will be very powerful. You look at -- it is going to take ’07 to get all these leases and rental problems all fixed, and it is going to take ’07 to get our cost structure more right-sized for our business. But you look to ’08, along with depreciation decreasing and all those expenses decreasing, I am quite encouraged that our expense structure can get there.

Patrick M. Byrne

Yes, it is almost like -- well, it is, not almost like -- it is true. We overshot the mark. We just overshot the mark and built an expense structure for a business that we thought might be $1.5 billion, $2 billion or so by now. But we have had a -- we have operated on a much thinner expense structure before, and it is actually one I think maybe we are more comfortable with then how chubby we got. I think we are all really looking forward to getting back.

We do not want to get as lean as we were before, but it feels good. It was not feeling like our nature to get to be living in as nice a space as we’re living and to have just gone with the high-end solutions to everything. It feels very satisfying for us to be getting back to that tighter expense structure, although we obviously cannot cut as deep as, we cannot make it as small as it was before.

We have $10 million or $11 million rolling out of depreciation next year, and then a similar size coming out the following year, so anyway -- Jonathan.

Jonathan E. Johnson

Yes, sir.

Patrick M. Byrne

I have some questions that have come in from e-mail that Kevin has given me that include stuff on, now that we are suing the entire financial world, shall I just punt that to you?

Jonathan E. Johnson

Sure.

Patrick M. Byrne

Anything you want to say about the lawsuit, why don’t you say it in one go and then we won’t talk about it. Be as brief as you would like.

Jonathan E. Johnson

Well, we filed a lawsuit on Friday against several of the prime brokers that we believe have been manipulating our stock by selling shares and not delivering those shares. We feel we have a good case. We feel we have a good damage model and we look forward to hearing their responses and their answers and starting the discovery. We feel we are well-represented by the attorneys that are handling it and so we are eager to go forward.

Patrick M. Byrne

Okay. I guess if anybody -- stick around, in case somebody else wants to talk about that. Good summary. Let’s see, what else. What are the new top line growth expectations internally? Jason, do you want to say anything to that?

Jason C. Lindsey

No. I would say that we are spending a lot of time trying to be more profitable and we are willing to make some trade-offs between lower growth and higher profitability, which are trade-offs we were not willing to make in the past because we were growing 100%. We thought as long as we could ride that train, we should.

We are spending a lot of time now crawling back from the 10% or 11% of sales we spent on marketing. We are judiciously slicing that back, cutting the worst-performing of that and seeing how it affects our gross profit dollars and we are going to continue to cut that until we pass the point on the curve of diminishing returns.

We don’t know. One of the reasons we don’t know and cannot give real good guidance on what our sales are going to be is because we are cutting back and watching it as we go. When we hit that point, we will let you know.

But I think the first big step is to go from the 10% or 11% we spend on marketing as a percentage of sales last year, we know we are going to cut that back to 9% and then 8% and then 7%. At some point around there, we will probably stop.

Patrick M. Byrne

Just in terms of what the comps look like for us, January last year was actually a very strong month. I know the first quarter is when things started to just really decelerate, but January was a very strong month. In fact, it was only after Valentine’s Day that the effects of all that NPS stuff started really washing through and customer behavior changed and it deteriorated for quite some time and then started coming back late in the year. But anyway, the point is in terms of what our growth numbers will look like just in the immediate future, January was a tough comp. February got a little bit easier, and then from there on, the comps get easier and easier.

But we are trying to -- we want to right-size the business for an $800 million business. We want to right-size the expense structure and not be counting on growth and be able to get to a profitable business at this size. Then, if the growth kicks in, we will be --

Jason C. Lindsey

I think also just generally, I think you are going to see growth continue to decrease as we determine the right efficiency of our marketing spend, and then eventually, hopefully later some time in the year, you will see it start to pick up. So I would think if you are building a model, that it would be worse in the first-half of the year and better in the second-half of the year. I don’t know what else to say other than that.

Patrick M. Byrne

Okay. I have a couple of other questions here. Now that you have had, Rob Wilson from Tiburon says now that you have had a major fire sale in Q406, when are you going to increase conversion? Is it fair to expect a major sales decline in Q407 if you decide to limit mark-downs?

I don’t really think so. I think that there are a lot of other effects going on than just what our pricing was on these products in Q4. There are a whole lot of things reflecting customer behavior and how we were treating them and such. So there are just too many other dynamics at work to limit it to just that.

There is another question. I don’t know if you have this in front of you, but Dave, you should probably answer this. Rob Wilson, Tiburon Research, asks: depreciation and amortization spiked to $12.4 million for cash, why a spike given a $7.5 million run-rate in Q1 through Q3? What quarterly rate should we expect going forward?

David K. Chidester

That is the effect of what we have talked about, some of the assets that we accelerated the depreciation on as we are moving out of some of this facility space. You will see it come back down to $8 million, $8.5 million the first-half of the year, then it will drop to $7 million, $7.5 million the second-half of the year. That is per quarter. And then you will see it continue to drop as we go into ’08, that kind of a trend.

Patrick M. Byrne

Okay, last of the written questions that have come in. Kevin, or Tanya, why don’t we go to anymore questions on the line?

Question-and-Answer Session

Operator

(Operator Instructions)

Your first question comes from the line of Aaron Kessler of Piper Jaffray. Please proceed.

Aaron Kessler - Piper Jaffray

Hi, guys, a couple of questions. First, in terms of the contribution margin, can you give us an update on when the target is to get positive on that? I think you and Jason had a bet on that last time.

Then also, in terms of what you are sourcing, how will that influence what your marketing costs are, such that if you are sourcing a lot less, are you going to be bidding on a lot fewer terms and much more strategic marketing than in the past? Thank you.

Patrick M. Byrne

As far as the contribution margin, I think our bet was for Q1, and I said that we would see it at 10%, Jason took the under. Jason, do you want to -- I will let you buy out now for --

Jason C. Lindsey

Well, if your guys in marketing would have hit their number, I might lose that bet, but since I’m not -- I don’t know. I will say that we have made much more progress much quicker than I would have expected, so I still take the under.

Patrick M. Byrne

He’ll take the under. It is going to be close. It is going to be close. It is going to be far better than it has been for quarters. I’m sorry, what was the second point?

Aaron Kessler - Piper Jaffray

Second was in terms of what you are sourcing, how does that impact what your marketing costs will be?

Patrick M. Byrne

Jason, do you want to handle part of that?

Jason C. Lindsey

I don’t think so. I’m not sure I understand the question.

Aaron Kessler - Piper Jaffray

Basically, I was saying if you are going to be sourcing a lot less inventory and I would assume you are re-bidding on a lot fewer keywords, a lot more strategic marketing and stuff you are actually going to have a higher turnover rate, so much more efficient marketing.

Patrick M. Byrne

Well, you hit the nail on the head. We think that there is stuff we probably overbid for. Our SKU selection is not going down so much as you would think, even though we are carrying much less inventory. We are replacing it with a lot of partner product. But people are I see looking at Alexa and talking about well, our traffic is way down. That is purposeful. What we have done is we have -- put it this way: if the traffic is down 45%, it does not mean the revenue is down 45%. What we have realized is we were buying a lot of traffic that -- our revenue per visitor you should see going up significantly from this quarter forward, just like our margin.

We have just stopped paying for a lot of traffic we realized was not economic for us.

Jason C. Lindsey

Yes, and I think your question, I do understand it now, assumes that because our inventory goes down, there is a direct correlation in our SKU count going down, and we are just really not seeing that.

Our SKU count has gone down some but nothing -- you know, our inventory has gone down. It is a fifth of what it was before. Our SKU count has gone down some but nothing even close to that, and so you do not see that change.

Additionally, I think as marketing is trying to be more efficient in cutting off their low-hanging fruit as well, I do think that they are bidding on less keywords but what it means is they are spending on less as a percentage of sales. I think it all kind of came down together. I do not think it is a dramatic effect.

Aaron Kessler - Piper Jaffray

And the marketing that you are cutting back is more on the brand side as opposed to performance-based search marketing?

Patrick M. Byrne

It has been on the brand side. A lot of it -- on a percentage basis, the brand side has taken the bigger cuts, although we are seeing that’s only been 20% of our spend anyway, so there is not as much as we can take out of that.

But we are taking a lot out of the online spend. We are looking at the profitability of customers from different channels and realizing we can afford to lose money on one channel because that channel is a channel that gives us just real bargain-basement shoppers who don’t come back or something whereas other channels are more valuable channels.

On a dollar basis, the majority of the cuts are coming out of online, but on a percentage, it would be higher on the offline.

Jason C. Lindsey

The good thing is we are looking at all of our marketing spend and looking at the return for that spend. As we decrease marketing spend, we are starting at the worst return and just moving up the ladder. I think that is the right way to do it.

Patrick M. Byrne

I would say that what we used to think of as broadly being in two groups, I think we are up to now, we have splintered it into 14 groups and we are looking at the payback literally every morning for the previous day and making allocation decisions weekly.

So we just have gotten more fine-grained about the whole thing.

Aaron Kessler - Piper Jaffray

Great. Thank you.

Operator

Your next question comes from the line of Justin Post of Merrill Lynch.

Justin Post - Merrill Lynch

Could you talk a little bit about your long-term business model? You said that the average transaction value is around $100 in the quarter. That was nice disclosure. I appreciate that. If you have gross margins in kind of the $16 to $17 range longer term -- I don’t know if that’s your target, if you can comment on that -- but how do you expect the cost per order on the marketing side to trend from here, obviously down? Where do you see your business model kind of getting to longer term that is going to really allow Overstock to be profitable?

Patrick M. Byrne

Well, when you say our costs per order, what are you referring to exactly? The marketing costs per order, the IT costs per order -- how are you -- ?

Justin Post - Merrill Lynch

The marketing costs, you either could break it down per order or average for incremental customers to the site to make an order.

Patrick M. Byrne

I think that you are -- my expectations on margin are a tad higher than what you just said. With our marketing costs per order, as Jason said, we are taking, we are moving down from 10% to 11% of that $100 to something already in the 8-ish range, but we think that should actually be able to come down more and even, and certainly if we just want to maintain an $800 million business, come down substantially from there.

To make that happen and keep the $800 million business, we have to be better at the whole CRM analytics side of things and the site conversion side of things.

Jason C. Lindsey

Yes, I look at our business model and say for one minute, you kind of have to exclude books because books we don’t make a lot of money on. We make some, but it generates a lot of traffic and customers. So if you exclude books out of the equation and just think about our income statement and how does it work long-term, I think margins of somewhere around 20%. You subtract 5 for marketing, 5 for IT, 5 for G&A and you have 5 of profit left. I think you can push those numbers around a point or two however you want because it is all theoretical and we are not there yet, but it is pretty easy to see all these expenses lining up to 20% gross margin, minus 5 for marketing, minus 5 for IT, minus 5 for G&A, with 5% left for profit. Is that fair, Patrick?

Patrick M. Byrne

Yes, that’s exactly right.

Justin Post - Merrill Lynch

One follow-up. How are your efforts to bring repeat customers back to Overstock playing out right now with the new technology?

Patrick M. Byrne

Well, that’s when I talked about the fellow who has located the kink in our migration. Think of it not just as a -- somebody goes from being a one-time shopper to a die-hard believer, but there is a whole migration in their behavior of many steps, of several steps. What we have found is there was one step, one step specifically that it just dropped off.

So we have discovered the step. Now we just have to fix that step, but we have isolated the problem.

Justin Post - Merrill Lynch

Thank you.

Operator

The next question comes from the line of Bill Lennan of First Albany. Please proceed.

William Lennan - First Albany

I have three for starters. Jason made the reference to gross margins --

Patrick M. Byrne

You are cutting out, Bill. Could you speak closer to the phone?

William Lennan - First Albany

Sure, how’s this?

Patrick M. Byrne

Much better.

William Lennan - First Albany

All right. Jason made some reference to gross margin on the direct business perhaps getting better than [partner] long-term. I wonder if you could tell us how. You’ve got a couple of levers you can throw there. What I am most interested in is your first cost, what you actually pay for underlying goods for improvement and/or just be better, smarter at buying, question number one.

Question number two is just a clarification. Where is the $5.5 million co-location predetermination cost in the P&L?

Question number three, technology comprises really two lines, depreciation and everything else. You talked a bit about depreciation. Where does everything else go? I am trying to get a handle on whether that is a headcount driven thing and how we should model the non-depreciation portion of technology. Thank you.

Patrick M. Byrne

Okay, I am just going to hit the last one first. IT, you can roughly think of our IT costs as being half depreciation, half headcount. You can see the headcount as staying stable and the depreciation dropping. Jason, is that fair?

Jason C. Lindsey

Yes, with the -- not quite fair. It is half depreciation, half everything else, and everything else IT, co-lo facilities, or excuse me, IT, the payments to Oracle for software, so it is half IT, half everything else. Everything else I agree with what you said.

Patrick M. Byrne

Yes, so the depreciation starts dropping away really a little bit in the second-half of this year but really starts dropping way in ’08 and is mostly gone by then. We really do not have significant capital expenditures we see certainly to maintain an $800 million business.

Jason, why don’t you go back to margins? I’m surprised you said 20%. I’m all over 20% but I didn’t know you were going to --

Jason C. Lindsey

Well, it is 20% if you exclude -- I mean, just taking books out of our business model hikes it up a couple of points right there. Even if you say 17% or 18%-plus minus books gets you pretty close to 20.

Our direct versus our partner business, you know, we have always said we should make more margin for our direct business because we are taking inventory risk. We haven’t got there. I think just by eliminating the 80% of our products that lost us money last year, we get a lot of the way there.

One of the reasons you won’t see that right away is because our infrastructure was built to hold this $120 million worth of capital, and so our, the amount of money that we are spending for warehouse space that we are not using, you will see in the first and second quarters, really puts a drag on our direct margins. But as we solve that problem, I’m confident that by the end of the year, assuming we solve our rent problem, you will see our direct margins be higher than our partner margins.

Patrick M. Byrne

Jason, you just put your finger on a problem we ought to mention. Right now, and going forward, I think our direct margins, certainly our juice is far higher, is significantly higher on the direct side than the indirect. The problem is the direct side, the difference between juice and GAAP margin is the fixed infrastructure, which we have on the direct side and which we don’t have on partner.

That infrastructure that was built is far more than we need now. So on a GAAP basis, how quickly are people going to see direct margins exceed indirect margins on a GAAP basis?

Jason C. Lindsey

Somewhere between the third and fourth quarter. Again, it just depends on, you’re asking me how quickly can we lease out empty warehouse spaces. That’s a tough one to answer.

Patrick M. Byrne

But what we have is we already, if our direct juice, which is just the margin but not counting the fixed warehouse cost, which we look at, that has taken a big surge forward as Jason has washed out all the stuff to which we should not be committing capital anymore. So we have never had a spread between them like this so positive where the direct has so much higher juice margin. However, now you add in the direct costs and we are stuck with this legacy. We built the infrastructure, both to support a higher level of sales and we did not imagine that we were going to be getting on a GAAP basis like 20 or 25 turns, which I think you are going to be seeing right away.

So we do have that infrastructure to get out of, and so you might not see it on a GAAP basis immediately, but Jason says the third quarter, so I am sure he is being conservative.

Jason C. Lindsey

All I am saying is I think somewhere between the third and the fourth quarter hopefully we will have our warehouses shrunk down to the right size for our business, so that is when I think you will see it.

He asked -- Bill asked three questions. The middle question I don’t think we answered, which is where do you see the $5.5 million co-location termination payment. Dave, correct me if I’m wrong, that is in our G&A expenses, is that correct?

David K. Chidester

It is actually in our technology expenses. It relates to the co-location facility.

Jason C. Lindsey

I think that answers all three of your questions.

William Lennan - First Albany

Yes, can I throw in one more, just quickly? The books, movies and video [inaudible] was significantly higher than the mix of revenue that we expected. We used to think of it as sort of a stealth marketing spend, leave money on the table segment so you can drive [inaudible]. What is the strategic role of BMVG in ’07? Should we expect it to remain a larger part of the mix to try and drive traffic in a less expensive way than television?

Patrick M. Byrne

Well, a couple of comments. One, its surge caught us by surprise too.

William Lennan - First Albany

Is it a surge or an escalation?

Patrick M. Byrne

Escalation, actually. Well, no, I think it was more of a surge. Or was that a joke?

William Lennan - First Albany

That was a bad joke.

Patrick M. Byrne

Okay. Well, I wondered if you meant was it going to stay. It did, in the holiday season, we just suddenly had a lot of new shoppers, but in general in 2006, it provides a very substantial portion, less than half, but a substantial fraction of our new customers, and the new customers go on to have customer value that is getting pretty close to average for everybody.

It’s a very cheap way of acquiring that substantial fraction of our customers. It also has a strategic role in that as we get more people, even if they are normally down bedding buyers or furniture buyers, as they shop in books and DVDs and music, we learn about them in ways that lets us recommend more, make more powerful recommendations for them, even back in furniture and bedding and such. We just learn more about them from the types of books and things -- I mean, our systems learn more. No human is consciously looking at any of it.

So it has that strategic role. It just gives us a richer psychographic picture. If you shop around our site now, you see that our recommendations at the product page level, sometimes even at the homepage level, are getting pretty good. I mean, they seem solid to me, the ones that I get.

We see a -- we definitely have the numbers to bear that out, and our gift-finder is working well. Now, we have to move this, the application of these recommendations and personalizations elsewhere in the site, but part of the information that drives that is getting people to buy or even just click around in books and movies, so it has a strategic role there too.

Operator

(Operator Instructions)

David K. Chidester

I think our hour is up, Patrick.

Patrick M. Byrne

Our hour is up. Let’s take one more question and then we will stop.

Operator

Your next question comes from the line of Scott Devitt of Stifel Nicolaus. Please proceed.

Scott Devitt - Stifel Nicolaus

Good morning. I wanted to be sure I understand the co-location agreement that you are exiting. The $5.5 million of expense, that impacted that fourth quarter?

Jason C. Lindsey

Correct.

Scott Devitt - Stifel Nicolaus

Okay, and so how much -- what is the annual expense that was flowing through?

Jason C. Lindsey

Well, that agreement [wasn’t signed] until half-way through the fourth quarter. We never actually even moved in there. Again, it was built-out. We told our landlords to build it out a year-and-a-half ago. It became available for us halfway through the year.

So the way to look at it is how much rent are we extinguishing from our income statement going forward, and I think that number is around $3 million a year.

Scott Devitt - Stifel Nicolaus

Jason, the $60 million that you quoted from consensus expectations of operating loss in ’07, is that inclusive of the $5 million or so with stock comp? Is that including that?

Jason C. Lindsey

Yes.

Scott Devitt - Stifel Nicolaus

Okay, so it is $55 million on a cash basis. Is that right?

Jason C. Lindsey

Yes, I think the number I had, the sheet I have that Dave printed out for me shows $66 million loss.

Scott Devitt - Stifel Nicolaus

Okay, so $66 million --

Jason C. Lindsey

But it actually -- yes, so 66 of operating loss, which should include stock comp in there.

Scott Devitt - Stifel Nicolaus

Okay. Then, as you think about the business over maybe a three-year time horizon so you can normalize CapEx, how much capital does it take to run the business? Amazon spends about 2.5% of revenue in CapEx, so I am trying to understand your business on a cash basis, normalizing for all these depreciation events. Is $20 million the right number on an annualized basis?

Patrick M. Byrne

Myself, I think that’s way high, but Dave or Jason, do you have a point of view?

Jason C. Lindsey

I think it’s high unless we are growing. There is a trade-off there, right? If you want to say we are growing 40%, then that might be --

Scott Devitt - Stifel Nicolaus

Let’s say you are growing 5% or 10%, what’s the run-rate CapEx requirement for the business?

Patrick M. Byrne

Tiny.

Jason C. Lindsey

Yes, if you are growing 5 or 10, it’s much less than 2.5%.

Patrick M. Byrne

The truth is that even with 40%, our systems are now built to handle so much more traffic and so much more volume that --

Jason C. Lindsey

Right, the first two years of 40% cost us almost nothing because we had already paid for that. Then after that, I am sure there is, of course there will be some incremental costs. But there is a trade-off. If you assume we are not going to grow, you cannot assume we are going to spend 2.5% on CapEx.

Patrick M. Byrne

Yes, if you, in fact, 40% over two years is basically double. I cannot imagine that we have to spend anything to beef our systems up with just one double from here.

Jason C. Lindsey

Right. I mean, there will be some incremental expenses. I don’t know what our software licenses and bandwidth and things like that, but as far as the hardware and what we can, the throughput of our systems, I don’t think we really need to invest much at all for the first double.

Patrick M. Byrne

Maybe even more than that.

David K. Chidester

The big reason is because in ’05 we spent almost 10% of sales on IT, so we just don’t need to spend it now.

Jason C. Lindsey

Like I said, we have already paid for it.

Patrick M. Byrne

I think if I believe the IT guys, they would say we could probably double twice. Well, I know what they tell me that this system can do and that system can do and the web servers and the ERP system and they paint numbers like we could be much more than tow to four times the current size, without really any new serious infrastructure. You know, at six to 10 times our current size, we would have to go out and think about some major investments.

Jason C. Lindsey

We tried to give you some insight into your question. We understand your question and hopefully you understand our answer, which is there are trade-offs between growth and how much we have to spend on CapEx, but understand that since we spent so much in ’05 on CapEx and ’04, well, ’05, that our next double or two has kind of already been paid for.

Scott Devitt - Stifel Nicolaus

I just have one final question. For my sake, let’s say it is $10 million-ish, 1% of revenue. So you can add back about $25 million of non-cash expenses because your depreciation today is higher than a run-rate, which would get you to a $35 million cash loss on a normalized basis at $750 million to $800 million in revenue.

Jason C. Lindsey

Well, you are assuming ’06 as normal.

Scott Devitt - Stifel Nicolaus

I’m assuming ’07, because you were talking to the $60 million. What I’m doing is I am trying to understand the depreciation as it exists today, how much capital it actually requires to run the business, and then what you are talking to in terms of the loss in ’07, which is a more normal loss because it begins to show the erosion of depreciation. So if I take CapEx, this $10 million number and I give you the benefit, so I give you the $25 million of cash, of non-cash costs back and I add that back to operating loss, it gets you to about $35 million in cash operating loss.

Whether that is the right number or if it is somewhere around that number, the final question is can you bridge us -- do you think your business is cash break-even around these levels? If so, can you walk us through the math that gets us from $35 million to zero in terms of the trail-off of depreciation, how you can cut heads and things of that nature?

Jason C. Lindsey

Yes, well, I think you are mixing two things. One, you are saying okay, ’07 and you are taking that $60 million number and now you are saying okay, let’s look at a normalized world. Well, part of that normalized world is okay, what does your income statement look like? Well, their $60 million income statement does not show where we think margins will eventually get. The consensus estimate for margins is 15% GAAP. It also has 9% marketing and then 5% growth in sales.

So I say for ’07, that seems like a reasonable guess, but then you start off and say well a normalized world is you are going to lose $60 million, okay let’s take the wash of CapEx in and out and okay, that gets you a 25% pick-up. How do you have a profitable business here? Well, you have a profitable business here because I don’t believe in the 15% gross margins on a steady state. I don’t believe in the 9% marketing on a steady state.

I think the assumption of ’07 is normal. That’s why I say don’t buy that.

Scott Devitt - Stifel Nicolaus

So if you think you can get to 20, that is $40 million, which gets you there, so maybe that answers my question.

Jason C. Lindsey

Yes, and I don’t think marketing at 9 is correct, so you know.

Scott Devitt - Stifel Nicolaus

Yes, okay. All right. Well, I’m just trying to -- it’s quite a dynamic model, so I’m just trying to understand.

Patrick M. Byrne

You guys -- we don’t envy you. You have a tough job.

Scott Devitt - Stifel Nicolaus

Thanks.

Patrick M. Byrne

Not as tough as ours, but a tough job. What else do you have, anything else?

Scott Devitt - Stifel Nicolaus

No, that’s it. Thanks a lot.

Patrick M. Byrne

Okay. Well, Jason, do you want to take anymore calls? It’s 10:08. Do you want to wrap it up?

Jason C. Lindsey

Yes, I think we’re good.

Patrick M. Byrne

Great. Well, thank you. Jason, any last comments from you?

Jason C. Lindsey

No, I think it was a tough year. I apologize to our owners. We lost a lot of money and it was a very bad year. I think ’07 is going to be a much better year but it is going to include a lot of expenses of the turnaround situation that we are in and I am optimistic for the future.

Patrick M. Byrne

I have never heard Jason so optimistic for the future, actually. Okay, that’s all we have to say. Thank you, owners, for sticking with us, those that have. We have been through tough times. ’06 was a wipeout year, and there was a lot of pain but a lot of it -- it’s not -- all the pain of tightening the belt and resizing our expense structure. We have our infrastructure fixed but our expense structure still is not there, but we have already taken steps at the end of the year and the first part of this year. We have made most of the decisions and made some of the changes and there is -- we just have to carry them out in the next few months.

But I actually have never heard Jason. I’m just not going to comment on my own emotions but those of you who know Jason know you probably never heard him so optimistic. But we do have our work cut out for us still, but we do think we have gotten through the toughest part.

Thank you all for your time. Bye-bye.

Operator

Thank you for your participation in today’s conference. This concludes the presentation. You may disconnect. Have a great day.

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