Overstock.com (NASDAQ:OSTK), also known as O.co, faces possible insolvency if current earnings trends continue and it cannot restructure two loans with U.S. Bank (NYSE:USB), its biggest creditor, by March 31, 2012 at the latest. In an apparent effort to mask its weakening net working capital position, it played a shell game to window dress its balance sheet at the end of the third quarter (September 30, 2011). Overstock.com owed U.S. Bank $20.329 million under the “Master Lease Agreement” (sale-leaseback) and another $17 million under a “Financing Agreement” (line of credit). Therefore, the company owes U.S. Bank $37.329 million under two loan agreements.
Last week Overstock.com surprised investors by reporting a third quarter $7.8 million net loss (diluted earnings per share of negative $0.33) compared to a net loss of $3.4 million (diluted earnings per share of negative $0.15) in the previous year’s third quarter. Its net loss was $0.10 per share higher than was projected by Wall Street analysts. So far, Overstock.com has lost $16 million in the first nine months of the year compared to only a $1.1 million loss during the previous year's nine month period.
"Likely" breach of debt covenant buried in footnotes
As I described in my last blog post, the company buried news of an impending default in its Master Lease Agreement (sale leaseback) with U.S. Bank on page 43 of its footnotes in its third quarter 10-Q report. The Master Lease Agreement with U.S. Bank requires Overstock.com "... to maintain a minimum Total Fixed Charge Coverage annualized ratio of at least 1.20:1.00, based on operating results, measured at the end of each fiscal quarter." The company revealed that, "… based on the results for the first three quarters of 2011, it is likely that we will be out of compliance with the Total Fixed Charge Coverage ratio at December 31, 2011 unless current trends improve substantially. We have held initial and collegial discussions with U.S. Bank regarding this potential non-compliance."
The 10-Q report gives a peek into Overstock.com’s "current trends" and since it was filed 27 days into the 92 day fourth quarter. According to the company’s own analysis, the projected fourth quarter numbers don’t look good “unless current trends improve substantially” in the next few weeks.
Window dressing its balance sheet
At the end of its third quarter, Overstock.com had $18.4 million of net working capital (current assets minus current liabilities). However, the company would have reported a mere $1.4 million of net working capital had it not played a shell game and window dressed its balance sheet during the third quarter. Apparently, the company wanted to avoid reporting dangerously low net working capital going into the fourth quarter, while at the same time it is trying to renegotiate terms of its Master Lease Agreement (sale leaseback) with U.S. Bank.
On September 21, 2011, Overstock.com borrowed $17 million under its Financing Agreement (line of credit) with U.S. Bank and used $7.5 million of internal cash to redeem $24.5 million of convertible debt before its December 1, 2011 due date (10-Q report page 16 and 33). It could have waited until the fourth quarter to redeem its convertible debt when it was due. Further, the convertible debt was unsecured debt, while the amount it borrowed from U.S. Bank is secured debt.
The convertible debt was classified on the company's balance sheet as a current liability at the end of its second quarter. The $17 million that it borrowed under its Financing Agreement (line of credit) is a long term debt (noncurrent liability) because payment is due on December 31, 2012 (10-Q report page 42). The company used secured long term debt (noncurrent liability) to replace an unsecured current liability in the quarter before its payment was due.
Had Overstock.com not borrowed that $17 million from U.S. Bank to redeem its convertible debentures before the end of the third quarter (September 30, 2011), it would have ended the quarter with a mere $1.4 million in working capital (current assets less current liabilities). In any case, its balance sheet window dressing is temporary, since the $17 million it borrowed will become a current liability by the end of the first quarter of 2012 (March 31, 2012) which is traditionally a weak quarter for the company.
At the end of the third quarter (September 30, 2011), Overstock.com owed U.S. Bank $20.329 million under its Master Lease Agreement (sale leaseback). As I detailed above, the company revealed that if current trends don’t "substantially improve" it "likely" won't be in compliance with certain minimum financial benchmarks required under the agreement. According to the Master Lease Agreement, an "Event of Default" includes the "...failure of Lessee to perform any term, covenant or condition of the Lease...." In such a case, if the company cannot restructure its Master Lease Agreement with U.S. Bank, the lender can require the company to immediately pay "…the entire amount of rent and other sums…."
Note, $14.485 million of the $20.329 million Overstock.com owed U.S. Bank under its Master Lease Agreement (sale leaseback) was classified as long term debt (noncurrent liability) as of the end of the third quarter (September 30, 2011). As I detailed above, Overstock.com had only $18.4 million of net working capital at the end of the third quarter. By window dressing its balance sheet, the company made it appear that it had adequate net working capital to pay all amounts due under that agreement in the event of a potential default. Even if we set aside the window dressing issue, the company barely had enough net working capital to pay all amounts due under the Master Lease Agreement in the event of a potential default.
The company is required to have $30 million in compensating balances deposited at U.S. Bank against its Master Lease Agreement (sale leaseback) and Financing Agreement (line of credit). Excluding those $30 million compensating cash balances, the company had only $95.8 million of current assets available to cover $101.6 million of current liabilities as of the end of its third quarter. (Note: The $101.6 million current liabilities amount excludes $5.8 million of current liabilities under the Master Lease Agreement).
In other words, Overstock.com could have a difficult time paying debts as they come due if continues to maintain $30 million in compensating cash balances at U.S. Bank. Further, the $17 million it borrowed under the Financing Agreement becomes classified at a current liability in the first quarter of 2012 which will reduce net working capital by the same amount.
Overstock.com may have to reduce its $30 million of compensating balances on deposit with U.S. Bank. However, if the company does not maintain its compensating balances with U.S. Bank it would default on both loan agreements totaling $37.3 million. Therefore, Overstock.com also may have to renegotiate its Financing Agreement (line of credit) with U.S. Bank.
Overstock.com also has to contend with an ongoing investigation by the Securities and Exchange Commission into securities law violations after this blog exposed it allegedly fabricating its earnings. So far, every single financial report issued from its inception to Q3 2009 had to be restated up to three times due to violations of Generally Accepted Accounting Principles.
The company is being sued by seven California District Attorneys who are alleging consumer fraud. They are seeking at least $15 million of restitution, fines, penalties and cost reimbursements from the company for allegedly defrauding consumers. The Judge in that case had to compel an uncooperative Overstock.com to turn over information to the California District Attorneys.
Earlier in the year, Google penalized Overstock.com for improperly gaming its search algorithm to boost its search rankings.
Two weeks ago, Overstock.com CEO Patrick Byrne, Deep Capture LLC, and Mark Mitchell, a writer for Deep Capture, were sued in a Canadian court for defamation. Deep Capture LLC is an affiliate of Overstock.com and its website was used to promote Byrne's delusional conspiracy theories and libel company critics. The judge ordered the Deep Capture website shut down.
Disclosure: I do not own any Overstock.com securities long or short.