Overstock.com Q3 2007 Earnings Call Transcript

Oct.19.07 | About: Overstock.com, Inc. (OSTK)

Overstock.com, Inc. (NASDAQ:OSTK)

Q3 2007 Earnings Call

October 19, 20079:00 am ET

Executives

David K. Chidester - Senior Vice President - Finance

Patrick M. Byrne - Chairman of the Board, Chief ExecutiveOfficer

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

Jonathan E. Johnson - Vice President, Corporate Affairs andLegal, Secretary

Analysts

Scott Devitt - Stifel Nicolaus

Aaron Kessler - Piper Jaffray

Shawn Milne - Oppenheimer

Brian Fenske - Lehman Brothers

Rob Wilson - Tiburon Research

John Reybold - Gagnon Securities

Operator

Good day, ladies and gentlemen, and welcome to the thirdquarter Overstock.com Inc. earnings conference call. My name is Lacey and I’ll beyour operator for today’s call. (Operator Instructions) I would now like toturn the presentation over to Mr. David Chidester, Senior Vice President ofFinance. Please proceed, sir.

David K. Chidester

Thank you. Good morning and welcome to Overstock.com’s thirdquarter 2007 earnings conference call. Joining me on the call today is Dr.Patrick Byrne, Chairman and CEO; and Jason Lindsey, President and ChiefOperating Officer. Before I turn to the financial results, please keep in mindthat the following discussion and responses to your questions reflectmanagement’s views as of today, October 19, 2007 only. As you listen to today’scall, I encourage you to have our press release in front of you, as ourfinancial results and detailed commentary are included and will correspond tomuch to the discussion that follows.

As we share information today to help you better understandour business, it is important to keep in mind that we will make statements inthe course of this conference call that state our intentions, hopes, beliefs,expectations, or predictions of the future. These constitute forward-lookingstatements for the purpose of the Safe Harbor provisions under the PrivateSecurities Litigation Reform within the meaning of Section 27-A of the SecuritiesAct of 1933 and Section 21-E of the Securities Exchange Act of 1934.

These forward-looking statements involve certain risks anduncertainties that could cause Overstock.com’s actual results to differmaterially from those projected in these forward-looking statements.Overstock.com disclaims any intention or obligation to revise anyforward-looking statements.

Additional information concerning important factors thatcould cause actual results to differ materially from those in theforward-looking statements is contained from time to time in documents that thecompany files with the SEC, including but not limited to its most recentreports on Forms 10-K, 10-Q, and 8-K.

This conference call and webcast may contain certainnon-GAAP financial measures. The company’swebsite, located at investors.overstock.com, includes a presentation of themost directly comparable financial measures calculated and presented inaccordance with GAAP. It also includes a reconciliation of the differencesbetween the non-GAAP financial measures with the most comparable financialmeasures presented in accordance with GAAP.

I will now review the financial results for the quarterending September 30, 2007. Please note that all comparisons will be against ourresults from the third quarter of 2006, unless otherwise stated.

Total revenues for the quarter increased 3% to $162 million.Our fulfillment partner business grew 22% and accounted for approximately 75%of our sales, while our direct business declined by 30% and accounted for 25%of our sales.

Gross profits increased 32% to $28 million; gross marginswere 17.5%, down 20 basis points from Q2 but a 390 basis point improvement overlast year. Marketing expenses decreased by nearly 50% to $8.8 million, or 5.5%of revenue. As a result, contribution margin increased to 12% and contributionprofit increased 375% to $19.4 million.

Technology and G&A expenses decreased by 11% to $24million on lower depreciation expense and corporate overhead. Our totaloperating loss was $4.9 million or 3% of revenue, a 1200 basis pointimprovement over last year.

Total operating expenses declined by 26%, meaning revenuegrowth significantly outpaced growth in operating expenses and there were norestructuring charges in the quarter.

Our net loss was $4.7 million, or $0.20 per share, comparedto a net loss of $24.5 million, or $1.19 per share last year. We generated $4.1million of positive EBITDA for the quarter, our first non-fourth quarter withpositive EBITDA and this is an $18 million increase from last year.

We ended the quarter with $91 million of cash and cashequivalents. Inventory, including prepaid inventory, increased to $27 millionin preparation for the holiday selling season. And although this is an increaseof $10 million over the previous quarter, this is down $46 million, or 63% fromthe $73 million of inventory and prepaid inventory we had at this time lastyear.

Finally, cash flow from operations was negative $3 millionfor the quarter, versus positive $760,000 last year. However, the trailing 12months operating cash flow was a positive $6 million compared to negative $20million over the same period last year.

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

Patrick M. Byrne

Good morning. Jason?

Jason C. Lindsey

Yeah.

Patrick M. Byrne

Okay, let’s go to the slides and I am going to start withslide 3, achievements. We feel great about this quarter. We returned topositive growth, having halved our marketing expense. We return to positiveEBITDA and there was one-time charges in the past -- restructuring chargesreally did turn out to be restructuring charges. And we have positive trailing12 months cash flow and I think that only goes up substantially from here.

Jason, anything you want to say about slide 3?

Jason C. Lindsey

Just to generate positive EBITDA in a non-Q4 quarter, we’venever done that in the history of our company, so I think that’s a bigachievement for us. It’s a good leading indicator of the emerging businessmodel that’s there.

I think cash flows, especially in our business, kind of aregoing to be out in front of profits, because our depreciation expense is sohigh. I am glad to generate positive EBITDA, especially in a non-Q4 quarter.

Patrick M. Byrne

Yeah, we’re gaining altitude and we’re gaining altitude,which -- well, we’ll get to that. Let’s go to slide 4, revenue and operatingexpense growth. Jason, so the revenue is the 3%, the operating expenses havebeen declining dramatically, so they are 26% down versus last year and thegross profits are up. Jason.

Jason C. Lindsey

I think what’s significant here is if you look at the bottomright-hand portion of this graph, you see the dark blue line, which is ouroperating expense, and it’s decreasing dramatically and our revenue growth has increased,and I don’t think those two lines have ever cross, at least not for the lastthree or four years.

So to finally see our revenue accelerating and our operatingexpense coming down, even when we were growing 100% or 80% or really highdouble-digit percent growth rates, we were having to invest so much in thebusiness at the time, our operating expenses were growing even faster. So thereal story here is those bottom two lines finally crossing and you are seeingoperating leverage in the business.

That doesn’t even include the almost 400 basis pointimprovement in gross margins as well, so you are really starting to see someoperating leverage out of the business. And if we can get growth to continue,you are really going to see it.

Patrick M. Byrne

Okay, next slide, gross margin, slide 5. And here thecomparison is between 13.6% last year and 17.5% this year. You’ll notice itdoes tick down each Q3 because we are in the -- we’re building up staff andtraining staff and then we’re obviously in customer care, so there’s a couplehundred -- no, 20 basis points of down-tick. But we actually think that this isa -- we’ll stay or even I think drift up a point or two from here, settingaside any mix change.

We are coming on very strong in electronics. We’ve greatlyexpended our -- I know that in the past electronics have never been our strongsuit but we have in the last two months gotten live with a very large supplierand I think our inventory, our selection of new electronic SKUs is up aboutten-fold, and that tends to be a higher -- a lower margin business, higheraverage order size business.

Jason, what do you want to say on margins?

Jason C. Lindsey

Well, the big comparison here is the same quarter a yearago, it’s up 390 basis points. I am pleased with our margins. I do think thereis some possible expansion going forward here but going against that is theheadwind, like you say. If our mix shifts more towards electronics, althoughthe gross margin percentage will cause it to decrease, there will beincremental sales so the gross profit dollars or gross margin dollars willincrease.

So I am pleased with where our margins are. Even if it comesdown, it’s a shift towards incremental sales which, as long as it’sincremental, positive gross margin dollars, I am still okay with it.

Patrick M. Byrne

You’ll notice at the bottom I put this quote from the secondquarter conference call last year, just that we’re going to see within a couplequarter, a dramatic increase in inventory turns and gross margins. That’sbecause, as I think the listeners know, I tend to try to be very open and giveeverybody -- somebody taught me once that you want to communicate with yourshareholders as if they are all your mother, what would you want you mother toknow?

So I give all this information and some certain knuckleheadswho I hope come on the call later say well, I’ll say 10 things and they’ll pickthe things that don’t work and jump up and down and ignore the ones that Icall, that we do manage to call.

So we called that. Slide 6, again, the inventory turns on a-- first of all, the inventory itself fell from $73 million to $27 million. Ofcourse, it ticked up from 18, and that is last year was an aberration when thethird quarter came down, because we were just watching inventory. But basicallyat the end -- in September, we are receiving like crazy to build our inventoryfor the Christmas season. That actually will probably get to $35 million or $40million in another couple of weeks before it comes down.

And the turns. Of course, the turns are 9.4 versus 4.1 oflast year. Feel great about that but again, it ticks down for the same reason,for just temporarily. Slide 7 is the GAAP turns and on a GAAP basis, last yearwere turned 9.7. This year, 29.2. Again, a slight down-tick from the previousquarter just as we build inventory at the end, but up from 9.7 last year to29.2. Jason.

Jason C. Lindsey

Just to clarify here, the bottom number is actual inventorythat we have in our own warehouse, which I think is a nice improvement from ayear ago. We’re turning our inventory much faster. The top line is really anindication of the business model that we have, so we get tailwind from turns ofinventory we don’t touch, so I think the bottom line is big improvement year overyear and that’s our internal systems and our internal inventory turning betterand the top line is really an indicator of the strength in our business model.

Patrick M. Byrne

Right. The top line and the spread between the two is reallyan indicator of the business model itself. Anything else?

Jason C. Lindsey

Nope.

Patrick M. Byrne

Okay, slide 8, GMROI. For those who are retail-centricinvestors, a lot of people look at GMROI. We -- 126% this quarter versus 28%last year, and Jason, would you make the same comment that the spread betweenthe lines is -- that basically the -- actually, the bottom line is at 39% to28% and again, that 28% is just a reflection of building the inventory at the very end of Q3. That’s acceptable forretailers just as retailers to have, to make in a quarter.

But you layer on top of it our partner business and that’swhat makes the business potentially so sweet. Jason.

Jason C. Lindsey

Yes, these are per quarter numbers. A lot of people are usedto looking at GMROI but a lot of people report it annualized. These are -- theyalmost -- the top number looks like a lot of other big retailers’ annualnumbers, but this really is just a quarterly number.

Patrick M. Byrne

Slide 9, sales and marketing expense, and it’s falling. Ithink we said at the beginning of this year that it was 10, 11 and was going todrop to 8, but we should actually be able to come down from there. Well, at 5.5-- we think 5% is the right annual number here, so it is half of where it wasin the third quarter of last year. Jason.

Jason C. Lindsey

Nothing to add.

Patrick M. Byrne

Okay. Half is an easy thing to say. Contribution margin,this is that bet Jason welched on. The contribution margin -- actually, no. Infairness, I missed it by a whisker. Contribution margin, when it was at 2%, wesaid it would be going up over 10 and it is 12.0. Not sure -- Jason, what areyour thoughts on this? Do you think it is going to go higher?

Jason C. Lindsey

Pass.

Patrick M. Byrne

Pass, okay. Go buy a vowel.

Jason C. Lindsey

It obviously proves to a much-improved business model. Thisis what -- this is just looking farther and farther down the income statementand we’ve just had a huge increase in the profitability of the business and aprofitable business model is emerging, so I am really encouraged by thisnumber, especially because it is so far down the income statement.

Patrick M. Byrne

Yes, and there’s lower fixed expenses beneath that. Slide11, I love this -- we said that you would first see growth return not at thetop of the income statement, but in the middle or two-thirds of the way down,the contribution dollars, and then growth in gross profit dollars and thengrowth in top line.

Well, the growth in contribution dollars at $19.4 million,that is up 376%. Of course, that’s a bit -- last year it had fallen off acliff, so that doesn’t mean as much. But if you went back two years at our best-- you know, when things were just going great and we were on the verge ofcoming off the rails, that was still $8.2 million, so we’ve more than doubledfrom there in two years. I feel great about that, actually. Jason.

Jason C. Lindsey

Pass.

Patrick M. Byrne

If we go to the next one, gross profit and contributiondollars, this is a new slide. The top of the bar is the gross profit dollarsand then the blue bar is what we spend in marketing expenses. Our gross profitdollars at $28.2 million are up 32% from the same quarter last year, and ourmarketing expenses again are half. So just the contribution dollar is going tobe the dark blue line.

Again, the only thing to say is that’s going on while theactual operating expense are dropping. Jason.

Jason C. Lindsey

Pass.

Patrick M. Byrne

Slide 13, EBITDA -- hallelujah. What do you say to this,Jason?

Jason C. Lindsey

I think this is -- I echo your hallelujah but I also thinkit is especially significant because the CapEx spend is so small. Well, we aregoing to get to that here in a slide or two but we’ve spent what, $300,000 orsomething in the quarter and so EBITDA to me is especially significant nowbecause EBITDA is unfair because you are not counting the depreciation when youlook at EBITDA, and if you have a business where you are continually pumping inCapEx, you don’t ever count the capital expenditures. But in this case, we haveEBITDA still -- or depreciation still significant and dropping, and it’sdropping so much because we are not plowing a lot of new money into capitalexpenditures, so I am very pleased to see positive EBITDA, but I think it isespecially important, just because we are not spending much at all on CapEx.

Patrick M. Byrne

Good point. Let’s go to slide 14, which says basically that.The capital expenditures are the earthquake and the depreciation is thetsunami, and the earthquake happened back in end of ’04 and all through ’05,and it has given rise to this tsunami, which is rolling through. We’rebasically on the back-end of the tsunami now.

We’ve -- and it really drops off pretty radically over thenext four or five quarters. It drops over -- it drops by almost two-thirds, itlooks like.

Jason C. Lindsey

Another way to look at that is that line that you see forcapital expenditures and the sum of the light blue lines, or light blue bars,all have to be the same. Basically what you are doing is you are taking thecapital expenditures and then the blue bars are the depreciation that flowsfrom it. So in other words, the blue bars are exactly the same as the line, andnow that the line is so much smaller, the blue bars in the future thereforewill be much smaller.

Patrick M. Byrne

We’ve actually spent -- although what’s our accumulateddepreciation, this year-to-date, high $20 million, 25, 26 or something -- 26,27? We’ve only spent $2.2 million in CapEx year-to-date and in this last quarter,a little over $300,000. And this isn’t -- what do you want to say about CapExgoing forward?

Jason C. Lindsey

I don’t see any big capital expenditures on the immediatehorizon. A year or two out, we might have some more data warehouse type thingsfor -- I don’t know, nothing like we’ve done in the past.

Patrick M. Byrne

Yeah, sort of $6 million, $5 million or $6 million or $7million, but that’s not this year and it’s not next year in our planning. Itwould be ’09 or after, so I can’t think of any big CapEx that we could dobefore that.

But I’m sure we’ll -- we’ll be creative. We might think ofsomething. Slide 15, net promoter score, my favorite. This, once again, thecomparison numbers are taken out of Fred Reichheld’s book. And this is an independentcompany which does this measurement for us constantly, and we’re up there withe-Bay, a little bit above Apple, according to this. We are in the superstarrank.

We just have a fanatic -- it’s great talking to customers.We have a fanatic following. We’re achieving cult status among some households,I’m told.

Slide 16, so once again, we knew it was going to get ugly,maybe not as ugly as it got but we thought we would come out of it smellinglike a rose. I would say that EBITDA line is pretty much what I was hoping orexpecting, and of course, it is going to rocket from here this quarter. I thinkwe’re back.

By being positive EBITDA and not having any capital expense,any survival questions are put to rest. We are accumulating cash. We are generatinga nice cash flow and I think it only goes up from here rather handily.

Jason.

Jason C. Lindsey

I think we can take questions.

Patrick M. Byrne

Okay. Questions.

Question-and-AnswerSession

Operator

(Operator Instructions) Our first question comes from theline of Scott Devitt with Stifel Nicolaus. Please proceed, sir.

Scott Devitt - StifelNicolaus

Congratulations on stabilizing the business. I have a fewquestions, first on the gross profit margins, which it does look like, when youlook at it year over year, improved dramatically. When you look at itsequentially, it actually dipped 20 basis points. I know long-term, you’vesuggested the business to get to your math, needs to be about 20% gross profitmargin and 5-5-5 interms of operating expenses to get to your optimal target of 5%.

I’m wondering how that directionally, your gross profitmargins are going to get to that 20% level.

And then I would just add to that gross profit marginquestion, historically you’ve said the direct business should be higher marginthan the partner business, because if you take inventory risk, you want togenerate a higher gross profit dollar per transaction. Even though inventory isdown so low, which means you’ve cleaned out all the excess inventory and, as Jasonhas said, historically you want to generate -- you wanted to keep the inventorythat generated 80% of the profitability and get rid of the other inventory, andyet gross profit margin in the direct business are still quite a bit belowpartner. So I’m trying to reconcile that so I can build a longer term modelfrom here, and then I have a couple of follow-ups. Thanks.

Jason C. Lindsey

Patrick, do you want to start or do you want me to start?

Patrick M. Byrne

I’ll hit the first one. The dip in gross profit margin, ingross margin I don’t think is significant. It is a -- partially it’s a functionof we bring in in the third quarter a lot of people who show up in our marginline, in our gross margin line, who are not really productive yet but we’ve gotto get them there to get ready for the fourth quarter, so there is always goingto be a pressure down in the third quarter, a couple of dozen basis points.

In addition, the mix --

Jason C. Lindsey

Can I just clarify there, Patrick? What you meant is trainingpeople at customer service and the warehouse and stuff like that.

Patrick M. Byrne

Correct. Would show up in our gross profit -- in our grossmargin. And they are not as productive in the first month or two, so that’s whythere’s a little bit of downward pressure in the third quarter.

And again, as electronics comes up, there is going to besome downward pressure but on the other hand, I think there is more -- I thinkthere is more upward pressure than downward pressure, both certainly in thefourth quarter because we get to leverage our fixed infrastructure for thequarter, with much higher sales. But also in general, I think that the analysisis still showing that we still have losers to cut and winners to expand in, andso I think that there is more -- long-term, more upward pressure than not, withthe possible exception if electronics really booms for us. Jason.

Jason C. Lindsey

You asked a couple of questions buried in there, I think.One was about our gross margins and the difference between the direct and thefulfillment business. If you look at our direct margins, they went from 9.8% ayear ago to 15.9% this year. So what’s that, Patrick -- so that’s a 600 basispoint improvement in a year, which I do think is significant.

The fulfillment business went from 15.8 to 18.0, so the --it also made a nice improvement. Now you are saying, rightfully so, the 15.9 isnot bigger than the 18.0, and the answer is yeah, you’re right, not yet but itsure has come up from the 9.8, and we do think that there is room to go.

That kind of leads in to the next question you asked aboutthe business model and how do you get to 20% and 5-5-5. It’s a good questionbut it’s a tough question to answer in Q3. We, like all retailers, are veryseasonal towards Christmas and it’s hard to look at a lot of numbers until youhave the fourth quarter revenue, and then you can look at the annual number.

That’s a long way of saying once we have -- we only havefixed warehouse costs for our direct business and yet we haven’t had the fourthquarter yet, so when you look at our margins of 15.9 and 18.0, which addtogether to the 17.5 when you weigh them, the direct business is the one thathas the most upside in the fourth quarter, because you get to amortize thosesame fixed warehouse costs over so much more volume when the fulfillmentpartner business just goes up with sales and doesn’t really scale in the fourthquarter that much.

I think when you look at it on an annualized basis, we’llget much closer and that gap will close quite a bit and then next year,hopefully, we think it will improve more.

If you look at the business model and 20%, 5-5-5, and then 5for operating profit, you know, I say this every time I talk about this. I saidthat, I don’t know, a year ago or however long it was, and when I said it Isaid plus or minus a point or two on any line, but we do think there is 5%operating profit to be had out of this business.

Just to note, when I said it, our gross margins for 2006were 12.7% and our total operating expenses were 24.8%, so that made anoperating income of minus 12.1%. We were a long, long ways away from evenshowing that we had a business model emerging.

Now, the last couple, so we did 17.5% margins this quarter.We do think there is some upside there. Then, if you look at the three fivesbefore you get to the operating income, the first is marketing. It’s gone from,what was it, 11 last year to 5.5 this year. It’s not five, but it’s gettingcloser. And again, all these numbers you have to look at once Q4 has happened.The other number is G&A. I think we are at 5.5%. What was G&A thisquarter, Dave?

David K. Chidester

This quarter was 7% -- sorry, 6%.

Jason C. Lindsey

But then when you look at it on an annualized basis, ofcourse G&A will go up with the fourth quarter but not as much as saleswill, and it will drop dramatically and on an annual basis, even for this year,I think it is going to get below 6%. So next year, as G&A comes down, Ithink we are pretty close on marketing and G&A.

Then you look at tech, and tech, 9% I think it was thisquarter but again, it doesn’t go up like sales will in the fourth quarter, sowhen you look at it at the end of the year -- well, tech this quarter was what,14.5? And I’m not giving you guidance. I’m just trying to do math for you. Iftech was say 15 inthe fourth quarter and revenue -- I don’t know, last year we did revenue of$300 million, just use that same number, 15 on $300 million, that’s 5%.

So when you annualize that number, you are going to get forthe year somewhere around 7, and with depreciation dropping as dramatically asit is, you know, you take each one of those numbers and they are pretty closeand it is not very hard at this point, especially the way the lines are --expenses are dropping and revenues coming up some. It is not that hard to seethat there definitely is operating profit to be made here.

Now, at what level will you actually have 5%? I don’t know.I hope it’s less than $1 billion but it is going to be somewhere, 900, a billion, somewhere aroundthere, I would guess. It depends on how long it takes and how much depreciationis bled out of our business by then.

But I think it is getting quite close.

Scott Devitt - StifelNicolaus

I appreciate that. I understand the seasonality dynamics. Imore was just trying to get at the point of why really be in the directbusiness, given the capital returns of not investing inventory are so muchhigher and you make more money. But I guess we can take that piece of itoffline and maybe your longer term goal is to not be in the direct business.

But I’ll just kind of lead into the next question, which isthis is kind of a competitive industry, I guess I would say, in terms of therebeing many alternatives. So optically, and those folks that have been aroundyour business for some time understand the optics of year-over-year dynamics,and when you look at it over a multi-year period, these things look quitedifferent.

So I’m wondering if some of the positive dynamics in termsof gross profit margins are peaking to a certain extent and the operatingexpenses are troughing, because whether you are talking e-bay, Amazon, orsmaller companies like Sierra Trading Post or [Zapost], I mean, nobody isslowing investment. So over time, you have to spend a pretty significant amountof the revenue of the company in terms of tech and content and CapEx to keep upcompetitively and prove a value proposition.

So I’m really again just trying to understand thatlong-term, you can’t not invest in the business and be in the most competitiveside of retail, which is the Internet and that I think is at the core ofwhether your business is under or over-valued. So that would be my questionabout how you think about the expense structure long-term and the need toinvest in it.

And then finally, just around legal costs, could you talkabout what the quarterly run-rate is in terms of your legal costs and how longyou think that’s going to be around, and kind of what’s going on in that area?Thanks.

Patrick M. Byrne

Thank you, Scott. Jason, do you want to hit that questionfirst before I hit it, or what?

Jason C. Lindsey

Sure. Well, you know, when we say not investing in CapEx,we’re talking about big hardware type systems to make all our website andeverything else run. We do have a large staff of developers and our focusrecently has been on improving the business and making things much better forthe customer experience, so we are investing a ton that you see in ourquarterly expense line in tech to improving and making a lot of newdevelopments in the business.

We are not buying new big irons and new hardware, so we didhave this business growing so fast that we built way out in front of it, andwhen we talk about not having to spend more on CapEx, we’re talking about nothaving to spend more and able to handle more traffic, because we built theinfrastructure to handle a much, much bigger business. But we’re not suggestingat all that we’re not investing in new developments for the website.

Patrick M. Byrne

I’m going to go back a step. First of all, I think thequickest way to summarize what you said on the operating profit point, oroperating margin, Jason, is when we were at minus 12, we said we could get toor we had a rough target of plus 5, and we’ve gotten from minus 12 to minus 2,so we’ve gotten two-thirds of the way there and it’s not even a fourth quarterbusiness yet. So that’s just how I would summarize that, all that arithmeticyou gave.

As far as not investing in the business, I think that’stotally false, although I can see, Scott, why it looks that way from theoutside. But we made the -- first of all, as Jason says, we made these hugecapital expenditures two years ago. What’s going on is we can now -- and webasically have a $10 million cushion, I think, in the business of if we had to,there’s another $10 million we can but, but we’re not because that $10 millionis going in to investing and figuring new things out and so on and so forth.

What is different is a great deal of things that we used todo in the -- that we would have done with hardware, or that we were doing withhardware, we can now do as code within the systems that we already have. Likewithin Teridata, Teridata has proven enormously powerful for us. The stuff weused to do like Propeller that was all about collaborative filtering, and ittook big boxes and all this stuff, well, that’s become just code running withinTeridata. And that really actually stands for a lot.

There’s more and more we are doing in the software asopposed to the hardware side of things, thanks to the big hardware systems webought. So you won’t see it in big CapEx. We actually have a new version ofPropeller that we’re testing now and it’s all being done out in the code ratherthan in big clusters.

Anything else on that? Oh, legal. Jonathan Johnson, SVP ofCorporate Legal Affairs, happens to be with me here in New York. Go ahead,Jonathan.

Jonathan E. Johnson

You asked about our legal expenses and run-rate. Our legalexpenses I think are probably at a quarterly low, at least for the past severalyears. Part of the reason for that is the two big cases we are involved in, theRocker/Gradient litigation and the prime broker litigation, are contingencymatters that we pay nothing to our lawyers at this point and incur very littleexpenses month to month on. So legal expenses are low right now.

I would comment that it’s been a great quarter for our legalteam. In the Rocker/Gradient case, both Rocker and Gradient have petitioned theCalifornia Supreme Court to review the case to try to get it dismissed, and theCalifornia Supreme Court summarily rejected their petition.

Patrick M. Byrne

Briskly, would you say briskly?

Jonathan E. Johnson

I would say briskly, and so we are back at trial court anddiscovery is starting. We anticipate sending our discovery request quickly,soon.

Patrick M. Byrne

It has been remitted,correct?

Jonathan E. Johnson

It has been remitted to the trial court so it is back in thetrial court’s jurisdiction. On the prime broker case, we had a great quarterthere too. The prime brokers have file a -- what in California is equivalent ofa motion to dismiss and the court, I think they drove the hoop and got blockedthere too. The court rejected most of those claims and so we are in discovery.Initial discovery has been served on the prime brokers and they’ve served someon us and things are going forward.

It’s been a long time waiting to get out our flashlights andstart looking in these people’s books, but that is where we are now.

Patrick M. Byrne

Are the wheels of justice going to grind fine on this one?

Jonathan E. Johnson

I tell our staff the opposite; the wheels of justice grindslow and fine, and they’ve proven to grind slow and I’m confident that theywill grind fine.

Patrick M. Byrne

Okay, well that was a nice sober analysis. Just what youwould want from your counselor.

I think it was a fantastic quarter that way. You know, whatI’m finding fascinating is the whole social side of this. Here these fellashave their pet journalists who are trying to waive any possible victory -- eventhe most minor is a big victory for these guys. Their argument that this isabout free speech, which is shameful -- this is illegal activity, just read theaffidavit. It has nothing to do with free speech.

But their argument, which has been dutifully repeated by JoeNocera of the New York Times and Roddy Boyd and so on and so forth, the what Icall their capture journalists, they -- well, that argument has now been deniedby the Marin County Court, the appellate court, three to nothing, theCalifornia Attorney General filed an amicus on our side, and now the SupremeCourt also denied it.

So I’m just kind of curious to see how it is these fellowsextract themselves from spinning out a party line that is becoming increasinglydivorced from reality. The best I can tell is happening is just a cone ofsilence has to descend over the whole thing, because -- so okay, that’s the endof the Scott Devitt question.

Scott Devitt - StifelNicolaus

Thank you.

Operator

Our next question comes from the line of Aaron Kessler withPiper Jaffray. Please proceed.

Aaron Kessler - PiperJaffray

Hey, guys. Congrats on the positive EBITDA in the non-Q4. Acouple of questions here; first, maybe you can give us a sense for of yourmarketing programs, which ones are showing the best ROI, either external orinternal? And maybe you can give us an update on your search engine marketingor search engine optimization, and then I have one follow-up.

Patrick M. Byrne

Okay, well, the marketing -- I think of this more as it’sbeen a combination of killing losers and expanding winners. But so far whatwe’ve seen is mostly killing or dialing down the least productive, the lowestROI parts of our marketing programs. But we are definitely getting a bettersite experience for people.

We have Mercado on our site, which gives not only greatsearch results but has let us morph to guided nav, which we really like. It’sextracting a higher revenue per visitor, although it’s not always easy to disaggregatehow much of that is from site design and how much of that is we’re buyingbetter visitors, or really we stopped buying bad visitors.

So all the decline in traffic that you see isn’t asmeaningful to us because a lot of that was traffic we realized was just notvery valuable. On the other hand -- by the way, as far as our traffic numbersgo, somebody -- Nielsen showed us up 10% for September. I don’t want to get toomuch into the details but the only traffic numbers that I ever look at that matchwhat we experience internally come from a company called HitWise, so if you aretrying to follow us, for some reason HitWise are the ones who are able tofigure out our traffic better than others.

As far as expanding -- so we are getting higher revenue pervisitors and getting better retention and so on and so forth, but I would say-- I said in my letter that we were about a third of the way through the list.That was the third that mostly had to do with dialing things down, identifyingsome things and dialing them down.

We have some good programs that are achieving really goodresults this year. They are still at the phase where they are small enough,they are not moving the needle too much but they are entering the size, they’venow reached the size where they can move the needle for next year. But beyondthat, I don’t want to discuss in any detail which ones are working better thanothers.

Aaron Kessler - PiperJaffray

Maybe if you could just give us a sense of where yourconversion rates are today and maybe what’s the long-term goal for those, andthen at what point should we expect you to switch back to maybe more of agrowth focus?

Patrick M. Byrne

Well, we’re about 3% conversion and I think that we aregoing to get through the fourth quarter, pile up some cash. I think we aregoing to -- frankly, I think we are going to smoke what everybody thinks thisquarter in terms of earnings, and then from there we’ll be positioned to startmoving the throttle back in a bit. But I really -- I think that this 5% numberon marketing is a good number. I don’t think it’s 5% each quarter. It probablygoes to 6% or a little bit more than 6% for quarters one, two and three, andthen drops below 5% in quarter four, and so then you get a blend of 5-somethingfor the year.

So I think that you will see us shift back in the firstquarter towards a growth emphasis but I don’t really -- we’re a little bit gunshy there. I don’t really -- I’m not intent on getting back to 50% growth. Wejust want to do everything right, move the throttle in, and as long as all ofthe other needles stay properly aligned, we’ll take it. And if that’s anindustry 15%, 20%, 25%, that’s fine. Although I think we are doing things rightenough now and we are finding these seams that have let our marketing becometwice as effective. It is not twice as effective per dollar as it was lastyear, and it only got that way because we did find some seams that we hadoverlooked that I don’t think I’d -- I think that there is a -- I wouldn’t shutout the possibility of getting back to some higher-than-industry growth rate.

Jason, do you want to add?

Jason C. Lindsey

No.

Aaron Kessler - PiperJaffray

Thank you, Patrick.

Jason C. Lindsey

I guess you did say one thing that caused me some pauseabout what you said about the estimates. Dave, are you still on the line?

David K. Chidester

Yes.

Jason C. Lindsey

What does the world have us for -- what are the estimatesfor net income for Q4 and for next year?

David K. Chidester

About $4 million for Q4, $4 million of net income and losingabout $12 million in 2008.

Jason C. Lindsey

So $4 million positive for Q4 and a loss of $12 million for2008?

David K. Chidester

Correct.

Jason C. Lindsey

I think 2008 is too low. I really -- I would really be disappointedif we don’t make money next year. For Q4, that seems reasonable to me butdefinitely as you go out to next year, I would really be disappointed if wedon’t make money next year.

Patrick M. Byrne

Jason and I always have healthy disagreements on this. Ithink that even the fourth quarter number is too conservative, but time willtell.

Jason C. Lindsey

We’ll see.

Patrick M. Byrne

We’ll see. Now, we have -- I show that we have on the lineShawn Milne, Brian Fenske, and Rob Wilson. And by the way, I meant what I say;Sam Antar, if you want to join us as an [inter-locketer], I have to stickaround -- I have to leave in 15 minutes but I’m hoping you’ll join, Sam. Butfirst, Operator, let’s go to Shawn Milne from Oppenheimer.

Operator

Our next question comes from the line of Shawn Milne withOppenheimer. Please proceed.

Shawn Milne -Oppenheimer

Thank you. Good morning, Patrick, and good quarter, here.Just kind of surprised people are still thinking through gross margins. That’sbeen now three quarters in a row of improvement.

Clearly the new news today is the 5% marketing number, andAaron talked about it a little bit. Can you dive in a little more, Patrick? Isit the elimination of more offline campaign that just didn’t get it done? Whatis really driving the improvement there?

And then, when you talked about potentially putting thethrottle down a little bit next year, would that be primarily with adcampaigns, more online campaigns that you can measure more real-time so wedon’t get into a situation of delevering that line next year?

And then I think there was some commentary about, last comment there was some commentary aboutpeople looking for a big loss next year. We were looking for about $22 millionin EBITDA in ’08, about a 3% EBITDA margin. David, would you care tocharacterize that? Thanks. Bye.

Patrick M. Byrne

Thank you, Shawn. I’ll hit these quickly; everything isbeing driven by CRM analysis and we’ve got great -- we finally have goodsystems that can do that heavy-duty work and really solid people. We’re gettingmore, really good statisticians an PHDs in math and statistics and people whohave done CRM before.

What we are looking at is customer value by differentchannels and what we are discovering is some channels are not -- on one levelof analysis, down to the gross profit dollars it generates or the gross profitminus the marketing costs, looked good to us but then, when you really get intothe lifetime value, they are not very good.

The other things, now that we can take it to that level ofgranularity, other areas which we didn’t think were that special, maybe, we nowsee are very special. We have in fact, our television expense is downsignificantly from a year or two ago. We are finding another thing that’shappening is some seams are opening up in the Internet that we thought wereored out -- I mean, they were mined out five years ago, five or six years ago,and people -- it’s one of these things where the water sloshes to one side ofthe bathtub and then the other.

There’s seams appearing where -- that people thought five orsix years ago, wow, they are overpriced and they stopped buying them and theyhave really dropped to the point that inventory is now available that does makesense in those seams. And of course, I don’t want to say where the arbitrageis, but Jason, why don’t I stop there and --

Jason C. Lindsey

Well, I think Shawn pinpointed the differences between ouroptimism and our outlook. I think 5% marketing is a best case scenario. If Iwere projecting the next couple of quarters, I definitely would not put in 5%,and I think that does pinpoint why you think the immediate future is going tobe -- you would guess it would be better than I would, so as you are buildingyour model, it’s up to you but I do think that’s kind of a best case scenario.

The reason I think that is because going from 11% to 5.5%,that was step one, which was identifying the losers and discarding them. Andthat caused a huge drop in our marketing expense as a percentage of sales.

Now, step two is identifying the winners and adding to them.And as we do that, and as we find places where we can spend money, we don’t bebashful about trying to get growth back.

So if we find some of those, which we are starting to seesome, I do think you will see us pore money into it and it could easily add upto 6% or 7% as a percentage of sales in the short run.

But if you look for the year next year, 3% EBITDA, Dave,I’ve never done the math as a percentage of sales. What does that number looklike to you?

David K. Chidester

Well, that’s -- I think we’ll probably have in the $27million to $30 million range in non-cash charges, so Shawn’s talking about $22million of EBITDA. That basically comes out to losing a few million dollarsnext year. I think he shows losing like $3 million next year.

So I don’t think that’s real far off. I don’t think we’retalking about making a lot of money.

Patrick M. Byrne

I thought that we were all comfortable saying that wethought we would be GAAP positive next year.

Jason C. Lindsey

Yes, I think we are and he’s saying loss of $3 million GAAPand we’re saying well, we think it’s going to be better than that.

Patrick M. Byrne

Okay. Of course, my expectations are higher than what Jasonand David say, but that’s what makes a horse race.

David K. Chidester

So obviously the other factor is where is revenue to know is3% the right number. I think the way to look at it is we think it is going tobe positive and we are going to have $27 million to $30 million in non-cashcharges, and where you come out from there, those are the two data points wecan give you.

Shawn Milne -Oppenheimer

Thank you.

Patrick M. Byrne

Remember, by the way, that there’s, in comparison with thisyear, there is $16 million, $17 million of what we called restructuring thisyear and it really is restructuring in the sense of it is not going to happenagain next year. There is only one possible thing that could -- well, you neverknow what’s possible, but the only thing that we would consider is if we canmove, if we can find a tenant for our building and we can move over into ourwarehouse, we could save $4 million or $5 million a year. But if we did that,there would probably be some CapEx and restructuring.

So other than that, so even what you see in our incomestatement for this year had $16 million or $17 million that just won’t be therenext year, and then there’s another 8 or 9 of depreciation that is reduced. Sowe get to start with a big tailwind for next year.

Okay, let’s go to Brian Fenske.

Operator

Our next question comes from the line of Brian Fenske withLehman Brothers. Please proceed.

Brian Fenske - LehmanBrothers

Good morning. Brian Fenske on for Doug Anmuth. I just had aquick question; how significant is the new product selection on the site? Iknow you said you signed up a big partner and consumer electronics selection ismuch better now on the site. I just want to get a feel for how significant thatwill be, particularly in the fourth quarter, and potential impact on conversionrates, and I guess average order size. Are you seeing an impact already? Thankyou.

Patrick M. Byrne

Thank you, Brian. I think it’s very significant, ourselection. And we talk about selection, we set aside books, movies, music,games, because those numbers are so much bigger. But our selection isdramatically increasing and we think going to go higher, not just inelectronics but really in category after category. Jason.

Jason C. Lindsey

Agreed.

Patrick M. Byrne

Do you want to give any numbers about the size of theselection?

Jason C. Lindsey

No, but it’s very dramatic. It’s gone up significantly.

Patrick M. Byrne

And I think it can go up quite a bit from here as well. Andthat’s again, electronics, you can add -- we can have 100,000 SKUs going upthere over the next six months. That sort of swamps all the other numbers, buteven within -- in fact, we just finished the rollover the other night to thenew Mercado 4.2 engine, and that was one of the main reasons for doing it, wasthat plus switching to the 64-bit architecture, will let us go over a millionSKUs. And that’s our goal.

Now, 800,000, 900,000 of them are books, movies, music,games, but we are all about expanding our selection at this point.

Let’s see, Rob Wilson, Tiburon.

Operator

Our next question comes from the line of Rob Wilson withTiburon Research. Please proceed.

Rob Wilson - TiburonResearch

Thank you, and good job. First question --

Patrick M. Byrne

Did that hurt so much, Rob? Did that hurt so much to say?I’m kidding. Rob, even though your -- you’ve always been a very fair guy, evenwhen you’ve said negative stuff about us. You’ve always been quite fair.

Rob Wilson - TiburonResearch

I call it as I see it. First question, on your gross profitmargins, do you feel like you’ve reached parity with Amazon, once you considerthe fulfillment costs in their income statement? Maybe we’ll start there.

Patrick M. Byrne

That’s a good -- I haven’t looked at their sheet for acouple of quarters, but yeah, I always thought that as I recall, they’rereporting around 24, but there is about 8, 7 or 8 in fulfillment that they move out.

David K. Chidester

Patrick, they are running, overall they are running in the15% to 16% range. Their domestic business is about 18%, and so we’re aboutequal with their North America business, but their international business isquite -- 600 or 700 basis points worse, so overall we are -- our margins are --our gross margins are higher than Amazon’s now.

Patrick M. Byrne

On an apples-to-apples basis?

David K. Chidester

Apples-to-apples, we’re about the same.

Rob Wilson - TiburonResearch

Okay, and looking at Q4, how fluid is your marketing budgetinternally? Are you prepared for any increase in competitive pressures ordownturn? What sort of range are we talking about as far as total marketingdollar spend in Q4?

Patrick M. Byrne

I missed the last 10 words -- say that again, Rob?

Rob Wilson - TiburonResearch

What sort of range are we looking at for total marketingspend in Q4? Are you prepared in case the competitive pressures worsen or themacro environment worsens, are you planning to spend more or less? Is there arange internally that you are working with?

Patrick M. Byrne

Yes, there is a -- I think if you -- on the order of $15million is the right number. There are different dials and some of them aresticky that can only be adjusted really once a quarter. Some of them are -- andthat’s probably 20% of the spend. Eighty-percent of the spend is with dialsthat can be adjusted weekly or daily or, in some cases, literally hourly weadjust them.

So overall, it is very fluid and we look at it everymorning. We meet five mornings a week and review. We have a very complicatedsheet that 20 of us in marketing sit and review column by column and makedecisions really each morning. And then there are some people who literally aredoing, making some changes hour by hour in their fields.

For example, key word buys on Google, you can actually makereal-time changes, so it is very fluid. Eight-percent of the spend is veryfluid.

Rob Wilson - TiburonResearch

So as we sit here today, you are kind of expecting to spend$15 million in Q4?

Patrick M. Byrne

Jason, do you want to comment on that?

Jason C. Lindsey

I think the answer is 80% of our spend is fluid, so itdepends.

Patrick M. Byrne

I think that would be a good estimate, don’t you?

Jason C. Lindsey

Yeah, I mean, if you had to just pick a number and guess,but again, so much of it is pay-for-performance, it really just depends on thesales that are coming in and the efficiency of the marketing spend, but yes, ifyou ask me to just pick a number today, that would probably be a good guess.

Patrick M. Byrne

If it went over that, I think that it would be because wealso were surprising to the upside on revenue.

Jason C. Lindsey

I don’t know about that.

Patrick M. Byrne

But if you said $15 million plus or minus $2 million, Ithink you’re 90% likely we hit that range.

Rob Wilson - TiburonResearch

Fair enough, and one final question; where do you expectyour cash balance to be at the end of the year?

Patrick M. Byrne

Well, at the end of the year, it is going to be ridiculouslyhigh but that’s because we are holding for another 15 days, a bunch of lenders’money. Jason, you have the model there in front of you. I’m in New York, by theway, so I don’t.

Jason C. Lindsey

I don’t. David, what do you --

David K. Chidester

I think it is going to be $150 million, $160 million, mostlikely, or even higher. But once again, a lot of that is like Patrick says,it’s just us holding money. But we finished last year about 130. I think thisyear we are going to be closer to 160.

Patrick M. Byrne

If you think of January 16th ending, I would think that $100million, $110 million sounds -- David?

David K. Chidester

Yeah, I think we’ll settle $110 million plus, somewhere inthat area. That’s probably the way to think about it.

Rob Wilson - TiburonResearch

Okay, well, appreciate you taking my call and again,Patrick, good job.

Patrick M. Byrne

Thank you, Rob. Nice to hear from you, and I got a messagethat someone from Gagnon, whom we have not heard from in ages, John Reybold --oh, from Gagnon is on the phone with question.

Operator

Our last question will come from the linen of John Reybold,Gagnon Securities. Please proceed.

John Reybold - GagnonSecurities

Hello, gentlemen. I was just curious; what percentage of thetraffic comes in through comparison shopping sites, such as shop.com and stufflike that?

Patrick M. Byrne

I’ll take that, John. It’s relatively small but we areworking very hard to get a major, to get our feeds built so we can expand inparticular, shop.com. When I say that there are these seams which we have sortof died out on and we are getting back on top of, that’s actually one of them,the comparative shopping engines.

We have to be able to adjust bids to the SKU level, whichmeans we have to be able to make analysis go to the SKU level, which is acapacity we’ve only recently gotten. Although I’m not going to give you theprecise number, I will tell you that it’s small and it’s smaller than it shouldbe and it’s a place that we are going to be hitting very hard. In fact, we areworking -- there’s a whole team working night and day and we are sliding pizzasunder the door so they can get a new bridge built to shop.com by Black Friday.

John Reybold - GagnonSecurities

Wonderful. Thank you.

Patrick M. Byrne

I have 10:02 -- Sam Antar, are you on the line? Come on,Sam. Okay, I’ve got to get over to a talk. I think everybody who’s on the phone.Jason, do you want to add anything?

Jason C. Lindsey

No, I just -- I’m encouraged with how things ended. I feellike for five years, we’ve had to ask the question every single quarter, whenare you going to be profitable? It feels good to finally say well, we are goingto be profitable this quarter, in Q4 and we’re going to be profitable nextyear. I think that’s a red letter day for Overstock and I think that cash flowsare a real leading indicator that things have improved and I’m encouraged. Sowatch the cash flows and EBITDA improve over the coming quarters.

Patrick M. Byrne

Yeah, it’s chop wood and carry water, but every once in awhile, you get to stop for a nice coldie. That being a cold lemonade in Utah.Thank you very much, those who have been believers and stayed with us and weare glad things are working out. Bye-bye.

Operator

Thank you for your participation in today’s conference. Thisconcludes your presentation. You may now disconnect. Good day.

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