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Overstock.com, Inc. (NASDAQ:OSTK)

Q2 2011 Earnings Call

July 28, 2011 11:30 am ET

Executives

Jonathan Johnson – President

Steve Chesnut – SVP, Finance and Risk Management

Patrick Byrne – Chairman & CEO

Analysts

Dan Chornous – The Benchmark Company

Nat Schindler – Bank of America

Operator

Good morning, my name is Celina, and I will be your conference operator today. At this time, I would like to welcome everyone to the O.co also known as Overstock.com earnings conference call. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks, there will be a question-and-answer session. (Operator instructions)

Thank you. It is my pleasure to turn today’s conference call over to Mr. Jonathan Johnson. Please go ahead, sir.

Jonathan Johnson

Thank you, Celina. Good morning, and welcome to our 2011 Q2 earnings conference call. Joining me on the call are Patrick Byrne, Chairman and CEO; and Steve Chesnut, Senior Vice President of Finance and Risk Management. We can’t predict the future, so let me first read the legal forward-looking statement language.

The following discussions and our responses to your questions reflect management’s views as of today, July 28th, 2011, and may include forward-looking statements. Actual results may differ materially. Additional information about factors that could potentially impact our financial results are included in the press release and Form 10-Q that were issued this morning, and on Form 10-K filed earlier this year.

During the call, we will discuss certain non-GAAP financial measures. The slides accompanying this webcast and our filings with the SEC each on our Investor Relations website contain additional disclosures regarding these non-GAAP measures, including reconciliations of these measures to the most comparable GAAP measures.

With that formality out of the way, let me turn the call over to Steve to highlight some financial results.

Steve Chesnut

Great. Thank you, Jonathan. Let me give you a brief overview of our financial results for the second quarter of 2011. Unless otherwise stated, all comparisons during the call today will be against our results from Q2 of 2010.

Let’s look at revenue. Revenue for the quarter increased by $3.7 million or 2%. The primary reason for the lower growth rate this quarter were declining traffic to the website, changes in our product mix, and the Google penalty that was in effect through April 21 of 2011.

Our gross profit declined by 4% and gross margin decreased by 110 basis points to 16.9%, due primarily to pricing initiatives. Contribution margin fell by 70 basis points to 11.1%. Combined technology and G&A expenses increased by 17%, largely due to increases in IT-related staffing and depreciation expense and higher legal expense. Small revenue growth, negative contribution growth, and rising operating expenses resulted in the net loss for the quarter of $7.8 million, an increased loss of $6.5 million compared to last year.

We ended Q2 with $83 million in cash and cash equivalents and $8 million of working capital. Free cash flow on a trailing 12-month basis was $23 million, a $3 million increase. This was largely due to spending $9 million less on capital expenditures, partially offset by a $6 million decrease in operating cash flow. I would encourage you to review our Form 10-Q that we filed today for a more detailed information on our results.

With that brief overview, let me turn the call over to Patrick.

Patrick Byrne

Thank you, Steve. I will be referring to the slide deck and continuing. In Slide 3, we just gone over all the facts on it. Slide 4, we did launch the discounted vacations platform, unveiled O.co Coliseum in Oakland, and launched a new type of shipping carbon-neutral shipping for Worldstock.

Slide 5, as I said before, these flywheels, they get spinning in one direction and when they spin well, that’s great. And when they are spinning against you, you have to break it. We have broken it this quarter, the compression in our revenue growth. We have broken that compression, finally showing a tiny bit of growth. But on the other hand, that came, Slide 6, that came at the cost of more gross margin than I would have liked, and we should have seen the decline of 4%.

Slide 7, contribution margin of 11.1% is not the right number for us. We did have a slight compression at how much we are spending on marketing versus the same quarter of last year, 6.1% to 5.8%. But at this point, having the 11.1% is not good, and there were some – we over-corrected in some areas and didn’t correct in the right areas and we ended up with that number.

Slide 8, quarterly contribution growth, I have been saying for a long time, pay attention to this. This is where we are really trying to run things to and that this was a bad result, and it has really been – well, it was a bad result for some, it’s gone negative in a long time. But in good use, I would say, when this is growing, it’s been growing at 40% or 50%, I say pay attention to that, and I am not going to change anything now. That’s the most important number to me after expense control, that number, we have to see that ticking up.

Slide 9, operating free cash flow has compressed to $23 million from $33 million same quarter last year – I am sorry – free cash flow is $23 million, cash flow from operation is $33 million. That’s a number of concern to us that it is compressed like that.

Slide 10, GAAP annualized inventory turns were finally at 7, which for a normal retail business can be considered fine. For us, I think with an emphasis on direct basis only. For us, we should be able to do much better than that, I would think with as many people a day coming into our stores. On a GAAP basis, we are running at 35 turns, which is of course great [ph]. I don’t think it means too much in this context.

GMROI, Slide 11, is 74%. That’s horrible, and we are just, again that’s on a direct basis, on a GAAP basis, I guess – I don’t know if we would say a GAAP GMROI, but at 745%, I really think that 1000% should be possible or more. So, that’s a lousy result.

Slide 12, there are some glimmers of excitement. We do just get better and better customer service all-time high or all-time recent high. I think it’s an all-time high for us, 62%, and again that’s people who contact the company as opposed to an 8% overall, that for people who the average American company their score. So, there is actually quite a bit of headwind against this number, against this 62%. So, we really have exceptional customer satisfaction.

Slide 13 is where basically the unique customers in the quarter was down 3%. The number of people who have purchased from us over the last year has increased 16% to just over 25 million people. Slide 14, new customers and CPA, the new customers are down 9% and the cost is up 5% versus same quarter last year of 20% to 21%. So, again that’s not good. Slide 15, B2C customer orders, flat to a little down, minus 3%. Slide 16, average order size up 6%, although we don’t see that as anything to celebrate one way or other, I know a lot of people look at that, but $128 is a fine number as for an average order size, but we actually don’t try to drive this one way or the other.

Slide 17, gross profit per transaction was basically flat or down a little bit, 2%. So, the number of transactions dropped, and then the gross profit per transaction dropped each a little bit, but it gave us a 4% decline in gross profit, and marketing really didn’t get any more efficient. The corporate employees are up 12%, but that is deliberate. If you broke corporate into software does versus other corporate, you see that at this point, our corporate has gone flat to even a little bit down. Their cost, their headcount that we have built up software development teams, and we think that’s the appropriate investment to be making in the future.

Slide 19, questions, I think we had one set of questions coming from Glenn Sarawacki [ph]. Standby a moment. For the trailing 12 quarters, revenues were up 8%, writes Glenn. Contribution dollars were up 5.7%. I hope to acknowledge these results are substandard, you are underperforming, dramatically underperforming Amazon. What’s their plan for improvement? Please be specific.

Yes, this is definitely substandard for the last 12 months, especially this quarter. Amazon, I would say, domestically is 25 times our size. And it’s substandard for us to be growing this much less at that small fraction of the size has not been – for much of our history, has not been like that. We have had for the last three or four years, once we came through our tough times, as we had spurts of growth, but have had trouble sustaining it. What is the plan for improvement? Well, let me get backed up. Is 12% to 15%, Glenn writes, is 12% to 15% contribution dollar a reasonable long-term goal, contribution dollar growth? And yes, I think the contribution dollar growth of 12% to 15% is reasonable. If you think that the industry is going to grow 12% to 15%, if the top line is growing 12% to 15%, there is different points of view on what the contribution line should be growing. Should we be looking for economies of scale out of your marketing or should we be giving, once you are covering your cost, should we be giving even more and more back to the consumers and pricing.

I am more of the latter school. At this point, I might think that strategically the right thing for us to be doing is growing our contribution dollars somewhat less than top line, but the question is removed at this point. But for the long term, yes, I think the 12% to 15% contribution dollar growth is a reasonable goal.

What’s the internal process for bringing new businesses to market? Well, we have had some losers and some winners, as either real estate do rest on options. On the other hand, insurance, cars and international. The first four have not done well. First four have not done well. Options, we shut down. Finally, we switched to marketplace some months ago, and we were in the process of developing a marketplace and then we decided to – the thing we wanted to do through the marketplace was something we could accomplish perhaps in a different way. So, we shut that down. I wouldn’t say it’s completely obvious and over the years, that loss does several million dollars.

I wouldn’t say it’s completely obvious. That auction site got us so many new customers who went on and spent at Overstock, something on the order, if we analyze how many people had never come to Overstock before, came to our auction site, for the first time came to our auction site having never bought from us, and then went on and bought from us, I think it’s on the order of $250 million over the years.

Now, with some of those people have found Overstock anyway and bought from us anyway, yes, but some very, and I don’t know how to estimate that off the top of my head, but some – the auction site did get us a lot of new customers who spend a lot of money in our shopping site. So, however, we are refocusing our company as O.co. The mantra is the savings engine, don’t know if that’s exactly what you are going to see in the marketplace, but as the savings engine, we are saying that as much to focus ourselves as in our customers’ minds of where we belong in the market, and we decided to get out of businesses where we can’t, where we were not bringing really legitimate savings to people and auctions, but auctions go to what auctions prices go to. There is no way that we have some – that we can make auctions come cheaper on our site for the consumer. So, real estate, same thing. Home is a negotiated price. We realize there is no way for us, now we can get mortgages, we get mortgage companies to offer mortgages a little bit cheaper and so on and so forth through our site, but ultimately there was no – if we are focused on being just about savings, then we can’t – we should get out of businesses where we can’t deliver, that we had no special edge in delivering savings.

I would say Zebo is turning out to cannibalize. Again, as far as customer base, we weren’t growing the customer base outside of our current customer base, and our current customer is doing better for us economically, just come in and do shopping than going to Zebo. So, we killed those. On the other hand, insurance, cars and international have been hatched differently. They are doing nicely for us. Insurance is just a couple of few weeks old, but it’s doing just fine for us. And those are industries where we really can bring, our car sites are very good car sites, with special deals, and lets you find special deals. It lets you save money.

If you are going car hunting, you can actually save money coming through O.co. Same with insurance, don’t know if anyone on the phone has used the insurance tab. But people really reporting savings internally within the company before we got decided to get into this, we had to demonstrate to ourselves that we could really deliver savings. And people who are using it are telling me they are getting savings.

International, same thing. Our business model there, we are passively – we would say, we are almost passively letting that spin-up. We are not putting capital broad yet, we are not doing any capital broad to support this business. We are just letting it spin up and getting the systems right, and just spinning up on its own. And it’s profitable and it’s spinning up gently on its own. And that to this point until we are in a more secure position within the U.S., that’s how we want to run it, we don’t want to be pushing any capital oversees [ph].

I would say other things that happened this quarter. It probably, the Google penalty was part of the quarter, and even when the Google penalty came off, we were penalized by Google for giving discount course to professors and students for mentioning out some blogs, but there sort of been open techniques discussed in the industry at that time, and was not generally perceived as – but that penalty ended at some point in the quarter, but (inaudible). There was also heavy, heavy discounting in the world of Macy’s and Saks Fifth Avenue. I was surprised of much couponing. That can’t be their business model at Saks to be offering 70% as constantly as they were in the last quarter. So, we sat that out, in fact, we have cut way back on couponing, and we have been playing at it a little bit conservative, maybe too conservative.

We have $24 million due in debt coming at the end of the year. That concerned us and we decided to play conservatively, so that wouldn’t – that wouldn’t be an issue, and it’s not going to be an issue. So, we probably did play – we played the game too conservatively and, I will leave it at Jonathan or Steve. Would you like to add to that?

Steve Chesnut

I think the way you have laid out the quarter, I think is the right perspective, Patrick. It was a tough quarter, I think we have learned, and going forward, we think we will have better quarters.

Jonathan Johnson

I would echo that.

Patrick Byrne

Are there any questions?

Jonathan Johnson

Celina? Is our moderator on?

Question-and-Answer Session

Operator

(Operator instructions) Your first question will come from the line of Dan Chornous with Benchmark.

Dan Chornous – The Benchmark Company

Hi, good afternoon, guys.

Patrick Byrne

Hi Dan.

Dan Chornous – The Benchmark Company

So, I guess I have a few questions here, sort of worked my way top to bottom. The first question I have is, you know, I know that you guys removed your affiliate agreements in California following the passage of the Amazon tax. Just wanted to see if you guys could give any color on how that might impact your top line growth going forward?

Patrick Byrne

Sure, the affiliates are in general about 12, have been historically, about 12% of our business. And unfortunately, a disproportionate share of affiliates live in California. So, something on the order of 35% to 40% live in California. So, you can multiply the two numbers and get just about what, how it would – its first order impact. On the other hand, it turns out if you don’t have the affiliates, some of the customers find you anyway, and in addition, a fair bit of the affiliates in other states, bigger affiliates just moved to nearby states, like Illinois, people moved to Wisconsin. I don’t know if people are going to leave California for Nevada. So, there is a first order effect that sort of looks in the mid-single digits percent and/or a little bit lower than that. And then a second order effect as customers and affiliates adjust.

Dan Chornous – The Benchmark Company

So, given that and given sort of what happened in this quarter, are you still targeting to be able to achieve growth at least somewhat comparable to the broader industry for the rest of this year?

Patrick Byrne

I don’t like to make quarter-by-quarter projections like that, but yes, I definitely consider it substandard when we are not able to grow. Most of our history, we grew so much faster than any industry and I consider it substandard when we are growing like this. In fact to the point that we are toying with the idea of saying, ‘look, we can just fix growth, we can fix growth to be whatever we wanted to be, but then, the bottom line suffers’. And I am at least toying with the idea of how much or different scenarios which say, this is fixed the growth to be some acceptable number, say x, and then, let’s model out really how much of a pain, how much pain we take in the bottom line at x, and just living with that.

Dan Chornous – The Benchmark Company

Okay. The direct side in the quarter was pretty significant drop-off. Obviously, you had your toughest comparison of the year. Was it really more of a business decision not to chase that revenue or was it just a function of the environment?

Patrick Byrne

It’s definitely a business decision not to chase that revenue. That’s definitely taking in place, but also the environment, if you mean, Macy’s and people like that has been a tough one.

Dan Chornous – The Benchmark Company

Okay. That’s helpful. Moving down to sort of the gross margin side, I know that you kind of, you guys mentioned the pricing initiatives and you kind of overspent on the gross margin. I was just wondering if you had a little more color there. I mean, it was a pretty significant drop-off from the first quarter especially and we had talked about keeping gross margins at sort of elevated levels. Is there any particular reason to see such a sharp decline there?

Patrick Byrne

We are still learning and getting our elasticity models tuned in, and so, they are not as tuned in as we hope they would be at this point. So, we are still having to have a fair bit of variability as we figure some things out. Although ultimately the margin concerns me less than the contribution margin.

Dan Chornous – The Benchmark Company

Great. And then, moving past sort of to your total operating expenses, they are actually a little bit less than I was looking for as a percentage of revenue, you guys sort of clamped down there a little bit. And you just talked about toying with the notion of maybe giving a little bit of sacrifice here to see if you can drive top line. Is there any reason for us to think that the second half of the year should accelerate significantly from sort of the trends we have seen through the first two quarters or is this trend just going to continue throughout the rest of the year?

Patrick Byrne

Certainly not. On the non-tech side of G&A, Steve Chesnut, why don’t you comment on overall?

Steve Chesnut

Yes, I think the trend that you are seeing and the expense structures what’s going to carry through the back half of the year, I don’t see big departures from recent trends.

Dan Chornous – The Benchmark Company

Great. That’s very helpful. And Patrick, you brought up the debt that’s coming due at the end of this year, I know that you guys paid down some debt in the first quarter. You have the cash on the balance sheet. So, I might as well ask the question, in terms of prior to uses of cash for you guys, you are looking to pay that down, is there a possibility of a share repurchase program, what are your thoughts on use of the cash here?

Patrick Byrne

First priority, unlike some organizations in this country, our first priority is yes. We pay our debts, we pay our interest, we pay our debt. We will always shift resources, we do whatever we have to do to not to fall. So, we won’t default and so I am comfortable with that. Steve Chesnut, do you want to add?

Jonathan Johnson

This is Jonathan. Just commenting on our senior notes, I don’t foresee those being an issue at all. They come due December 1, and we have a plan to pay them off. Steve?

Steve Chesnut

And then I think we are going to stay very conservative about cash management as we go through the back half of the year.

Dan Chornous – The Benchmark Company

Okay. And then just two quick things on any updates you could give us on the impending litigation and then sort of a broader question, just sort of your thoughts on how the O.co expansion is going so far and any future plans you might have? Thanks very much.

Patrick Byrne

Thank you. I will say, on the O.co expansion and toss it to you, on the O.co expansion, a surprising number, depending on how you measure the share of mind, somewhere between 20% and 50% of our customers have made the shift to O.co instead of Overstock.com, again depending on how you would measure it. So, we are encouraged by that. In fact, we have been stepping up the speed at which we make that transition. Although that they may also induce some drag with the customers who have not made the shift. It’s not out of the question that, that creates some drag with them.

So, then I will toss it to you Jonathan, you can explore that comment further or talk about litigation.

Jonathan Johnson

Yes, first on the rebranding, there may be some drag, but I think it’s going well. And the articles we see, the press out there we see on the new name and the customer acceptance, I am pleased with how that’s working, and I think it’s the right thing for the organization. On the litigation, there should be some significant news next week. We had a hearing yesterday in San Francisco on whether the court will allow our racketeering claim against Goldman Sachs and Merrill Lynch to continue. The judge took it under advisement, an opinion on (inaudible) Monday afternoon. He also heard whether that racketeering claim, which has been filed under seal, meaning it can’t be seen by the public, will be allowed to be publicized. Both the Rolling Stone and The Economist magazine have filed motions with the court to see our racketeering claim.

And so, Monday afternoon, the judge will decide on both of those. Regardless of the result, we have a claim that is going forward under California law, trial continues to be scheduled for the 5th of December. And we like what we are finding and we like our case.

Dan Chornous – The Benchmark Company

All right, great. Thanks very much, guys.

Patrick Byrne

Thank you very much. I will add to that. It’s a matter of – it’s interesting to me that while the mainstream media sits on its hand, as you have one end of the spectrum, the Rolling Stone and at the other end of the spectrum, The Economist joining up to do – how do you describe it, Jonathan? I don’t want to get a word wrong.

Jonathan Johnson

Goldman Sachs and Merrill Lynch have filed what’s called a motion to seal to keep our racketeering claim out of the public eyes, and those publications have filed in opposition to that motion to seal.

Patrick Byrne

Okay. Are there any more questions?

Operator

Your final question comes from the line of Nat Schindler with Bank of America.

Nat Schindler – Bank of America

Okay. Hi guys. I was just wondering if you could help us out on the kind of non-tech related expenses in the quarter, and what percent and kind of how much of those are, because it seems in every quarter, there is something illegal that is happening and it changes so much quarter-to-quarter, gets it very hard to track. So, could you help us on legal, any extraordinary payments this quarter or is it all just kind of this is a steady state level aspect?

Patrick Byrne

Our legal bills are definitely running high. So, taking on Goldman and Merrill is an expensive proposition. They have gone up from the second quarter significantly from second quarter of last year. And so, they are quite steep. But we think it’s worth and the right thing to do. Jonathan, you want to take a ball?

Jonathan Johnson

Yes, I would say always the last month before trial. When you are finishing discovery and going, we anticipate we will be going through some of these judgment motions and by going into trial, expenses wrap up. But we feel, the management as a Board that the candle is worth again.

Nat Schindler – Bank of America

Okay. And anything on any other particular legal issues going on right now, or is it just basically, the spend is related to the prime broker suit?

Jonathan Johnson

We do have a trial coming up in October in Texas. It’s a patent trial and there have been some increased expenses as we hear trial on that, too.

Nat Schindler – Bank of America

Okay. And looking at what happened to gross margin this time, you did pretty significant – it looks like a pullback in pricing to drive revenue, and it didn’t really flow through. While at the same time you have kept marketing spend as a percentage of revenue relatively constant for a while, are you just not getting the message out there that when you do a significant pricing pullback and pricing initiatives, and in which case, do you have to start going back to the marketing line to push the brand and push for new customers to see the pricing, or is it just simply – is that the pricing change was not significant enough to spur conversions?

Patrick Byrne

I think that you have hit the nail on the head. I think that the pricing message has not gotten out there as it should have. Our prices are really sharp now. There was a period where maybe as we measure it now, we see that they had gotten not as sharp as we would hope some time ago that still over 50% of the product being lower priced than anywhere else, but not 90%. And now, we are back sort of 90% to 100% of our products are priced at or below anywhere else you can find them. And I don’t think that message has gotten back out to the public. But we are doing things, some of them are internal things that sort of improved that visibility and some of them are making it very much clear in our marketing message.

Nat Schindler – Bank of America

Okay. And a final question, you bought the O.co brand, the rebranding is great, but why didn’t you buy O.com, too?

Patrick Byrne

O.com, Jonathan?

Jonathan Johnson

The dot.com group has not released single letters.

Nat Schindler – Bank of America

Okay. Now, I remember. So, understood, thanks.

Jonathan Johnson

I will note that over the last quarter, Google has bought G.co; Amazon, A.co, and there have been other significant dot.co purchasers, shortest URL in the business.

Nat Schindler – Bank of America

Okay. Thank you.

Patrick Byrne

Thank you, Nat.

Operator

There are no further questions.

Patrick Byrne

Okay. Shareholders, we were always honest telling you how we feel about the quarter, and we have good quarters, we don’t pump it or say they are great quarters, and when we have weak quarters, we don’t pump it and say they were good quarters. This was a bad quarter, and we have had some surprising, couple of surprisingly good quarters in the last year, but this was a weak quarter, and we know we have to fix things, and we think we see what needs to be fixed (inaudible). Thank you very much. Look forward to talking to everybody in three months.

Jonathan Johnson

Thanks.

Operator

This will conclude today’s conference. You may now disconnect your lines.

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