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Overstock.com, Inc. (NASDAQ:OSTK)

Q2 2008 Earnings Call Transcript

July 18, 2008 11:00 am ET

Executives

David Chidester – SVP, Finance

Patrick Byrne – Chairman and CEO

Jonathan Johnson – SVP, Corporate Affairs & Legal

Analysts

Shawn Milne – Oppenheimer

Nat Schindler – Merrill Lynch

Scott Devitt – Stifel Nicolaus & Company

Dom Lacava – Canaccord Adams

Andrew Watts – Oaktree Capital

Michael Ongey – Ibis Managment

Operator

Good day, ladies and gentlemen, and welcome to the Second Quarter 2008 Overstock.com Incorporated Earnings Conference Call. My name is Jendy and I will be your conference coordinator for today. At this time all participants are in a listen-only mode. We will be facilitating a question-and-answer session towards the end of today’s conference. (Operator instructions) As a reminder, this conference call is being recorded for replay purposes.

I would now turn the call over to Mr. David Chidester, Senior Vice President of Finance. Please proceed.

David Chidester

Thank you. Good morning and welcome to Overstock.com's second quarter 2008 conference call. Joining me on the call today is Dr. Patrick Byrne, Chairman and CEO; and Jonathan Johnson, Senior Vice-President, Corporate Affairs and Legal.

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, July 18, 2008 only. As you listen to today's call I encourage you to have our press release that was issued this morning 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 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934.

These forward-looking statements involve certain risks and uncertainties that could cause Overstock.com's actual results to differ materially from those projected in these forward-looking statements. Overstock.com disclaims any intention or obligation to revise any forward-looking statements. Additional information concerning important factors that could cause actual results to differ materially from those in the forward-looking statements is contained from time-to-time in documents that the Company files with the SEC, including, but not limited to, its most recent reports on Forms 10-K, 10-Q, 8-K, and S-1.

I will now review the financial results for the quarter ending June 30, 2008. Please refer to our earnings press release for the full financial statements, and further details regarding our results. All comparisons will be against our results from Q2 2007 unless otherwise stated.

Total revenue for the quarter was $189 million, up 27%. Fulfillment partner revenue, which accounted for 79% of total revenues, grew 41%, while direct revenues were down 8%. Note that our revenue deferral at the end of the quarter for orders shipped but not delivered was $12 million, compared to $12.8 million at the end of Q1. This resulted in an increase to our Q2 revenues of approximately $800,000 or one-half of 1% of our growth.

Total gross margins were 18.1%, up 40 basis points. Gross profit dollars grew 30% to $34 million. And note that the net effect of the revenue deferral on gross profit was an increase of approximately $100,000.

Sales and marketing expenses were up 79% to $14 million. Combined technology and G&A expenses increased 2% to $26 million. And total operating expenses were up 2%. Excluding the $6 million of restructuring last year, operating expenses were up 20%.

The operating loss for the quarter was $6.3 million, compared to $13.5 million, and our net loss was $6.5 million, or $0.28 per share, compared to a net loss of $13.8 million, or $0.58 per share.

Weighted average outstanding for the quarter were $22.7 million. We generated $1.1 million in EBITDA and $9.6 million over the last 12 months. Total non-cash expenses were $7.4 million, including $1.5 million of stock-based compensation.

Cash flow from operations was positive $500,000 this quarter versus $15 million last year. While on a trailing 12-month basis cash flow from operations was positive $13 million versus $9 million last year.

Capital expenditures during the quarter were $5 million, bringing them to $6.5 million year-to-date, and we expect capital expenditures to come in at the high end of our $10 million to $15 million estimate for the year.

We ended the quarter with $87 million in cash and marketable securities and over $58 million in working capital.

And with that, I will turn the call over to Patrick.

Patrick Byrne

Nicely read and described, David. I am here with Jonathan Johnson who’ll be commenting on some legal affairs and the end of the slide deck. You will control your own progress through the slide deck. I’m going to start now at tab three, David having read tab two. And the highlights are again the 27% growth, the record high personal best 18.1% gross margin, fourth consecutive quarter of positive EBITDA, and fifth consecutive quarter of positive trailing 12 month operating cash flow, which means that, once again, we feel sort of we are through the hurricane and we are sort of putting that chapter behind us.

Slide 4, you see it’s revenue growth, again, 27%. Why don’t we mention here? David, you mentioned to me yesterday that people are expecting – we don’t try to be real formal and give strict guidance, but people are expecting more like 17% through the rest of the year. I am not – I don’t think that’s a bad assumption. I can tell you that the toughest comp months for us in last year were July, August, and November. So those are going to be the months that are hard – hardest to grow against. On the other hand, I think we’ll do pretty well in September, and I think December. So – anyway the toughest comp month – the months where we did unseasonably well last year were July, August, and November. So I think that that – I would probably pick a number that’s little bit higher than 17%, but that’s what Dave tells me what analysts are at and it seems to make sense, right ballpark anyway.

This is Slide 5, gross profit growth 30%. That’s fine. Contribution growth took a dive for this quarter. We basically started a new program within marketing and rather than take a year and do it slowly and so we basically said we can spend $4 million or $5 million this quarter, figure it out, and just come up the learning curve more quickly. We are glad we did. It did cost us a net number,, it cost us, but it let us figure something out. The task was sort of create new marketing chimneys and then dabbled with them slowly for a long time, we’re just spending little bit of money to figure them out, and we just accelerated the process this time. So that did hurt our contribution significantly this quarter. But we have already, I would say, dialed that in, and we know exactly where we will be spending money in that – we refined the spending in that chimney at the end of the second quarter.

Slide 7, gross margin and contribution, over 10%, 10.5%. We like that. I’d like to see it get back to – at this point 10% is a nice minimum and I think 12% would be a good place to look.

Okay. Slide 8, contribution dollars. Basically steady with previous quarter 19.8%, 19.9%.

Revenues outpacing fixed expenses, as are the gross profits. We actually think that we can get this – the fixed expenses into negative growth territory – back into negative growth territory. At least in the next quarter two. Dave, would you agree with that or am I being – ?

David Chidester

Yes, I think that we will see tech and G&A flat to down from Q2 levels in the third and fourth quarters.

Patrick Byrne

Great. Slide number 10. EBITDA and this excludes stock based compensation. Do you want to mention that Dave? Do you want to – ?

David Chidester

Just – there is different ways people calculate EBITDA I think. We just want to make sure it’s clear that our calculation of EBITDA does include stock based compensation.

Patrick Byrne

Is that the convention?

David Chidester

It’s completely the convention in our industry and I think because it’s a new – it only came about a couple of years ago, everybody pretty much excludes it when they talk about EBITDA and talk about cash earnings.

Patrick Byrne

Well, okay. Well, EBITDA fourth consecutive quarter of positive EBITDA. Again, I am not a huge fan of this number but it is meaningful in some circumstances and it does describe something for us.

Slide 11, trailing twelve month EBITDA is now at $9.6 million. I think that has a – that’s the valley of death and we seem to be climbing out the far side

Slide 12, I am pausing because I realize some people may have slower systems. Cash flow from operations, we are now trailing $12.7 million, and Dave do you want to talk about that in the balance sheet effect and so on and so forth?

David Chidester

Yes, I mean we spent 2006 and 2007 really squeezing a lot of dollars out of the balance sheet as we reduced inventory and so we start to hit that point at the end – by the second quarter of last year we had sort of squeezed everything out of the balance sheet and so you did see a big jump in our cash flow by the second quarter of last year. And it wasn’t because we were losing money, but we were – we took $60 million out of inventory over that time. And so, over the last year, our balance sheet is almost identical from a year ago. And so what you will see in the cash flow from operations much more of it you will see is actual cash earnings driving the operating cash flows and not just squeezing dollars out of the balance sheet.

Patrick Byrne

Yes. Okay. Slide 13, inventory turns, now running on a GAAP basis at 38. We will take that.

Slide 14, GMROI, annualized, 854%. We have to bet here, whether we can get that into double – quadruple digits. If I – if we do, I am taking a vacation, if we – GMROI in quadruple digits.

Today, but not of course I think we are – that’s a huge goal for which to reach. Dave, do you have any comments on that?

David Chidester

No.

Patrick Byrne

Slide 15; net promoter score, I am extremely proud of this in particular. Again the people who contact us through service with a problem have – still end up with positive 29% whereas the average American company is, according to Fred Reichheld who invented this, is 8%, overall. We are at 29% of the customer having initiative to call customer service or 74 overall. So, this is just – this has really dialed in beautifully.

Slide 16, so these are the highlights. I will make a few other points. So, let’s see, as far as growth I mentioned that if the analysts who are out there at 17%. Dave, do you want to comment on that number?

David Chidester

Oh, yes, I mean it’s our all-time high gross margin number.

Patrick Byrne

No, I am just talking about the growth for Q3 and Q4—

David Chidester

Oh, I think you said it. I think you’ve already talked about it. I think you are right.

Patrick Byrne

I am hoping to do a tad better, but well I think Dave is finer with that too. So, our expenses are dialed in, we are through the maelstrom. We are just trying to tighten the rigging. Actually I will repeat something I said in a couple of few interviews in the last month, that Dave told me some time ago that the market – the analysts average having us at sort of a minus $12 million GAAP loss this quarter – this year, and I can see where they get their numbers. If we hit all our marks and if everything goes very nicely, I think we could maybe make a few – we could maybe make as much as 10. So to me that range of minus 12 to plus 10 is a reasonable range for the year to expect. And as the year develops and that range of reasonable expectations narrows, I will probably have something to say after the third quarter.

I know I have mentioned some of these guys before, but just I want to give mad props to a couple of our vendors that I’ve been working with in marketing, Armature , Mercado , and Bizarre Voice . We are doing big projects with them three are a delight to work with and bring so much value to the table.

With that I am going to turn it over to Jonathan who probably wants to give a legal update.

Jonathan Johnson

Thanks, Patrick. A few things to report that happened this last quarter. I think most importantly, the letter we received from the SEC that says that they finished they were working on and were not recommending any enforcement against us. So, it is nice to have the SEC having looked at what we’ve done and decided not to do anything. Nothing more than we expected, but nice to have it done.

On our two suits out in California, which people seem fairly interested in, you should know we are in the discovery phase and we have begun to receive documents from our friends at Rocker and Gradient. Can’t comment a lot on what they are saying, but I will say it, there is some teeth-pulling to get them to provide what they are obligated to provide. But we will get them.

Patrick Byrne

Nice about me.

Jonathan Johnson

They say lots about you, Patrick. In the Pawnbroker case, we have begun to receive trading records from each of the Pawnbroker defendants as to all their trades in Overstock.com. It not in the form as promised or as required by the judge, but we will get there and we are encouraged by what we see.

Last thing I just want to mention is we have been advocating for some changes in regulation show, the SEC rule that governs short selling for quite sometime and we are pleased by some of the things that are happening. One, the SEC has reopened the comment period on its proposal to eliminate what’s known as the option market maker exception, which is a loophole that allows for abusive naked short selling. We are hopeful that the SEC will eliminate that exception sometime this year. So that’s good news.

Also, we have been advocating for long time that the SEC have a pre-borrow requirement for any one short sells and interestingly, this week, the SEC proposed just such a pre-borrow requirement for 19 selected equities.

Just a second, one thing I want to say is I heard a quote the other day that the equity markets have become animal farm. All equities are created equal. It’s just that some equities are more equal than others.

Patrick Byrne

And my comment on the just what happened earlier this week was its – Oh we realize naked shorting is wrong, and it’s bad, and its destroying companies , it’s fraud, it’s illegal, we really got to do something about it for these two quasi governmental corporations and the banks who have been enabling it for everybody else.

Jonathan Johnson

Anyway, we are pleased by that development at the SEC; we certainly hope that they extend that protection to all equities in the market.

Patrick Byrne

Hey, do we not pay our taxes, Jonathan? I thought we were taxpayers, I thought the rule of law applied to us, I guess I missed something in civics class.

Jonathan Johnson

We are pleased with what’s going on. So, anyway, I should say that as an aside, things are going well on the legal front. They are just ancillary to what’s happening at the business. I think the business has turned around and steady as she goes. And so back to you Patrick.

Patrick Byrne

Okay. I will stop being a smart aleck. We have a few questions that have been mailed in. I don’t know if you want the name associated with them. Actually, Dave, did you have any of Sam’s questions? Did he post any or send them?

David Chidester

I don’t.

Patrick Byrne

Okay. Let’s see. Okay, well, question number one that’s been mailed in, why the uptick in capital expenditures this quarter? What’s the capital expenditure expectation for the full year? Do you want to say something first, Dave, and then I will put some color on that?

David Chidester

Sure. I think we are – the expenditures are both IT infrastructure upgrades, a lot of it is just old equipment that we are refreshing and then also we are doing a lot of our own internal development and have a lot of development projects. We have built out our development staff and so – in the past I think it was mostly just buying big boxes and now I think a lot of what we are doing is projects that are going to hopefully either cut costs or increase contribution dollars. So, they are true investments, I think, into our business.

Patrick Byrne

I will put two pieces of commentary on that. One is that, yes, we started the year, I think thinking roughly $10 million, and we actually thought there was a couple of million dollars of cushion. But we have taken – we have always been – we have always – our development – we wanted to expense as much as possible and not capitalize. And whats happened is this year, I think that we have gone to a system where we are capitalizing some of our development and that was more. Do you want to comment on that specific point, Dave?

David Chidester

Well, I think it’s just the bigger and bigger our own development staff gets, the more and more we track what they are doing and properly capitalize projects that aresoftware that we are building internally. Our staff is probably going to be double what it was at the beginning of the year, by the end of the year.

Patrick Byrne

It’s already…

David Chidester

So, we are doing a lot more of it.

Patrick Byrne

It’s already five times what it was a year and a half ago, the actual development staff. And capital expenditure – so that’s one-reason capital expenditures are going up. The projects that are really long term ones are actually getting capitalized, which I am personally against, but it’s GAAP. I’d rather expense it all right now.

The other thing is we did have some vendors come in who gave us some very good deals on some hardware and software, that we had not anticipated purchasing this year. B but they gave us attractive enough deals that we decided to go ahead and do it. So I think that what is the capital expenditure expectations for the full year? It starts looking more like 15 to me now. Do you agree, Dave?

David Chidester

Yes, I think it will be at least 15.

Patrick Byrne

In particular there were a couple of things that we thought we were going to be buying next years and somebody came and made very aggressive offers for us to buy this year and so we did so.

David Chidester

Yes, there is at least $3 million to $4 million that we won't have to spend next year.

Patrick Byrne

Yes. So, we thought it was in the interest of the Company to, we got a good deal on it and so we reached.

Okay, when do you envision the Company generating a positive operating margin for the fiscal quarter and/or year? Can you generate a positive operating margin in Q4 this year?

I think yes. Dave, do you think yes?

David Chidester

Yes, definitely. We believe that this fourth quarter we‘ll definitely generate positive operating margin.

Patrick Byrne

And, go ahead.

David Chidester

And then hopefully, depending on how well we do in the fourth quarter and we have said this before but if we really can drive a good operating margin in the fourth quarter and continue to grow, we don’t think it’s unreasonable to think that we could start doing that next year.

Patrick Byrne

And as I said, my waveform is a curve from say minus 12 is the world – is the analysts’ estimate, minus $12 million for the year. I think if you drew a curve between say there and plus 10 and you’d, I think that that’s80% likely it’s going to – would come in at somewhere under that curve.

David Chidester

Yes, I mean the thing to keep in mind is that our tech and G&A is really going to stay flat next year. And so we have been running a 7.5% marketing in the first half of the year. We think we can get more effective than that, much more effective. And if we do that, continue to grow, and our operating expenses aren’t growing with us, we do see that leverage potential next year.

Patrick Byrne

Yes, I was talking about just for this year. I sort of feel it’s about 80% likely that the final number for the year, GAAP net income is minus 12 to plus 10 or something, I am not sure how it distributes within that curve, but next year, you see tech and G&A as being flat with this year, or even going down a bit?

David Chidester

Potentially going down, if anything.

Patrick Byrne

Yes, we have so much depreciation dropping out of the system. I tend to think on a GAAP basis, is 100 million the right number?

David Chidester

I think 100 million is the number to just, yes, keep in mind for this year and next and potentially even 2010 just depending what opportunities come along and how much we reinvest into technology in 2009.

Patrick Byrne

And then next, okay, next quarter, next email. Excellent execution this quarter. Where does the existing share repurchase authorization stand? What are your thoughts about doing additional share repurchase at these price levels?

Well, we were authorized to spend $20 million, we spent $12 million in the first quarter and my bad that we didn’t spend more, and so we still have $8 million left on the authorization. We didn’t use any in the second quarter.

I’d like to hear this is, I hope you don’t mind. – This is from Glen Cyravac at Alstom Capital. I’d love if you want to call in, Glen, if you are on the phone and want to give me your thoughts on that. I mean call in and I’d love to hear from anybody on the phone what their thoughts are.

I have – and so what are your thoughts on share repurchase at these price levels? Well I see that we may – I see that there has been a change, a rather significant change in price so far today. Jonathan, what do you want us – what can I say? Why don’t you answer?

Jonathan Johnson

Well, we have more money under the authorization spend. We will do analysis here and when it looks like a good price, when we think market is undervalued, that’s we will consult with the Board and make decisions. But we are not committing to buy any; we are not committing not to buy anything.

Patrick Byrne

I like it. I do think, of course, we are entering a period of where we should be risk-averse, financially, in terms of just the secular conditions. I think that this crack that we are in is that we have – I have been gloom and doom for a few years. You have may have heard, I have been down on this whole financial industry, and I think that we are entering a crack that’s going to make the 1929 crash look like a tea party, which I have been saying for three years. So although I actually think that we are at attractive levels now, I am probably being more cautious than I would be in past times. I have no idea what the future holds. For the last few years, Jonathan and I and Dave, we had a pretty good idea of what the future held. And now that it’s here and everybody sees it and actually it’s kind of funny. For once this week, reporters are calling and saying kind of Wow! You guys called this and what’s going to happen next? And for the first time, I have no idea. I have no idea what’s beyond the event horizon. We knew that this was going to happen, but I have no idea what’s going to happen next.

Jonathan Johnson

You know, as the secular market goes down, we think it’s nice to have some cash so that when companies go out of business we are in place that we can buy their inventory. That’s what we do.

Patrick Byrne

That’s a rather ghoulish thought, rather ghoulish way to put it. But we do think that it is time for us and everybody to be defensive, to drive defensibly in this economy. On the other hand, there’s two things happen – two things may happen, one of which I am sure of and one of which I am not. The thing that will happen is it becomes very good time to be a liquidator, not just from the worst case scenario , bankruptcies, also just because in a supply line anytime there is uncertainty, anytime there is beta, you get excess inventory. So this is the time that people start calling and saying I’ve got excess inventory, those calls have started. They didn’t really materially affect this quarter, but I know that by June we were starting to get a lot of calls, and we are getting a lot of calls, and a lot of – you will be hearing the new partners in the near future and a lot of manufacturers and such. So, we are getting back in a period of getting a lot of calls.

The other thing that can happen is on the demand side. Well, of course, it cuts both ways. You go into a recession and I think this is going to be an inflationary recession, a bad one. That, of course, looks like people will cut back on their spending and tighten their belts. On the other hand, value shopping is typically not a middle class phenomenon. It’s a lower income people and affluent people value shop. The middle class people pay for retail. Then you get into a downturn and middle class people seek to retain the standard of living that they achieved and that’s when they shift towards value shopping. So, I think it’s going to be sluggish. I am hearing that people who are around the retail industry saying, you are going to take a big downturn in June and then late June and such. And that’s what others here as reporting. Now we didn’t actually see that in late June. But, on the other hand – so, the consumer spending is going to decline. People are going to tighten their belts. On the other hand, some of them start just thinking about how to pinch a penny better, in which case we are a great solution.

And also on the supply side, things definitely are better for us.

David Chidester

Yes, I know, with the credit market tightening, we have seen with a lot of stores closing, not just companies going bankrupt, retailers closing lot of their stores, which is definitely – we have seen inventory in the chain that is backed up to the manufacturers. In bedding, and furniture, jewelry we have seen some good deals come our way.

Patrick Byrne

Yes. And it isn’t like the stores call us up as they close but it’s that the manufacturers who have stuff in the pipeline who are expected to be selling that stuff, so—

David Chidester

Yes, they cancel orders.

Patrick Byrne

Okay. Well, it’s 9.30. Why don’t we take questions? And, Sam, you are in my book, if you are on the phone, you are welcome to come on the line and be an adult and ask a few questions.

Question-and-Answer Session

Operator

(Operator instructions) Your first question will come from the line of Shawn Milne of Oppenheimer. Please proceed.

Shawn Milne – Oppenheimer

Yes, good morning, Patrick, couple of questions for you. Can you describe a little bit more what marketing programs you were working on in the June quarter and why you decided to step up by about $4 million higher, and what gives you confidence that you will be able to dial that back, going forward?

Secondly, we have done some work on the fuel surcharge issue, which is, as you know, generally on a lagged basis. How are you expecting to work through that? I see your direct gross margins went down. Does that have anything to do with it? But your partner margins were very strong.

And then lastly, I am having a hard time reconciling your comment about GAAP net income, a positive 10. I am not sure how you, I know you generally have some optimistic bounds, but that seems to be a little bit overly optimistic. How would that imply a very strong fourth quarter. If you can give any more color on that. Thank you.

Patrick Byrne

Thank you. Okay, marketing program, well we are confident we can dial – we are developing new areas in marketing, things we have never done. And since anyone who is on the Internet can see it, I will mention, for example, we are doing banners. We left banners seven or eight years ago thinking that they – and barely done banner advertising since then thinking that it was over-priced and they didn’t give you you’re the return for expense. Well, the technology has gotten much better, and it’s possible to target better and do smarter things, and we are –we have gotten that program to positive level anyway. I mean we knew that starting off it was going to lose money as we start of figured it out. It’s taking four or five months, but we have at least gotten into a nice positive contribution.

There was another program, I don’t want to mention actually, which we have developed a new chimney. I don’t want to mention exactly what it was, but we decided Gee, it’s going to ultimately take $5 million or $6 million of spending across this area to sort out where the opportunities were. And then we could do that over two or three years, or we actually did it over the first two quarters we have found some areas within it that work, and we have cut everything back until it’s now 40 grand a week, but it’s a nice 40 grand a week expense. So it was worth that much to figure out and it’s actually =a nice new channel for us. So I am confident we can cut that back as we’ve already trimmed that out.

Fuel, Dave, do you want to talk about the impact of fuel on the direct business?

David Chidester

Yes, I don’t think the fuel surcharges, while it has some impact, it is not anything significant. The changes you are saying in direct margins aren’t a direct reflection of the fuel surcharges. You know the direct margins affects more some mix shift. You are seeing some mix of higher margin stuff moving away from direct and into partner. And also just some of the stores in our direct business didn’t do as well this year as they did last year, but it’s not a direct effect of fuel surcharges.

Patrick Byrne

And the true is fuel surcharges would hurt us on the partner business just as much as the direct because what ends up happening is the partners pass it on to us. We have gotten – we have developed, thanks to our colleague, James Joyce, who is actually a director, but he is out here helping a lot – we have focused on using our aggregated demand to hold the line against price increases. And in fact the user aggregated demand has squeezed cost out of the system. I think there are still a lot of basis points to squeeze out of our supply chain, with James and his colleagues here. So, anything else you want to say, Dave or Jonathan on that?

Okay. And as far as, yes, the 10 million is – we were going two quarters in a row 27%. If we grow 17% and probably the lower end of that range of minus 12 to plus 10 million GAAP net income is reasonable. If we can actually keep growing in the range of 20% to 25% even, I think a number that’s more like basically breakeven for the year is reasonable. And if we somehow accelerate to 30% or 40% over the rest of the year then we would I think make about – we would make about $10 million. So, you now know as much as I do about how we are going to grow, I mean we really do. There are all these different elements passing back and forth in the dark and the consumer economy. The economy is on the one hand giving us a lot more opportunities, and consumers tightening their belt. On the other hand we are a discount shop. You put all that in a bag and shake it up, and I don’t know if you get really 17% or you get 35%. So, that’s why I think there is that kind of a range. I think it’s just probably more prudent to think about the growth rate through the rest of the year of 17% to 20%.

Shawn Milne – Oppenheimer

Just one quick follow up and all things being equal, all else being equal, if you are going to dial back marketing why would growth really accelerate again?

Patrick Byrne

Well, 200 basis points of the marketing this quarter was just sort of this new exploration that’s already been dialed out. And we are really substituting,we are getting much more for our marketing dollar these days. There is another 200,we spent last year 250 basis points in an area of marketing that when we finished this project I think it should drop to about half of that (inaudible) in a completely different area. So I think of there being hundreds of basis points to drop out of marketing, 100, 200 maybe even 300,maybe even 250 to drop out just to support sort of the both the marketing intensity that we now have, I hope to have finished that project by June, we haven’t finished it. And it’s probably going to be August or September, at best. So, but what we are doing is we are getting technology. We were spending 9% to 13% on marketing couple of years ago and still shrinking. We are now spending 7% and we are growing 27%. And I think that there is sort of an automatic 100 basis points or more that we can drop out now without any effect on the business, maybe even a fair bit more than that. And at the same time we are bringing new technology on line and testing it and just getting smarter with technology so that it doesn’t really cost anything. And if that stuff works and adds kind of 15% growth, that’s how I get a number like 30%.That’s 10% growth from the site design changes and the personalization. We are doing a lot of personalization and site design changes. And if we can get 10% or 15% out of that, then we will end up growing at 35%, and if not, the other number is something like 17% to 20%. That’s reasonable. If Jonathan wants to say to something…

Jonathan Johnson

You know, Shawn, you asked a good question on the GAAP net income bounds and how we can say it will fall somewhere between minus 12 and plus 10. I think plus 10 is as bullish as minus 12 is bearish. And Patrick said 80% chance it falls in that range. That’s a big range and I am pretty confident that we are going to be covered by that range.

Shawn Milne – Oppenheimer

Okay. Thank you.

Patrick Byrne

Thank you, Shawn, nice to hear from you.

Operator

Your next question will come from the line of Nat Schindler of Merrill Lynch. Please proceed.

Nat Schindler – Merrill Lynch

Hi, Patrick, two quick questions. One, we have seen some indications and you could look at the comp score, which is of whatever questionable worth or not, but decrease in unique used growth in June from earlier in the quarter. And there are some maybe some concern on the market place as the consumer began to feel the pinch mostly kind of in June, late June, maybe July. Have you seen anything to date on that? And is that something that we should be concerned about going in – about the consumer-spending going in over the next few months?

Patrick Byrne

Well, for us the comp score is pretty good. I will also recommend Hitwise. Hitwise is extremely accurate at least we have noticed for our Company. We have seen for July, a drop in growth rate, because like I said that’s because we had a very strong July last year and August and we also had a very, very strong November. So, it’s a little hard for me to dis-aggregate how much of that it is. But, yes, in terms of absolute numbers, no, actually. Dave, aren’t we? In terms of absolute numbers we haven’t seen a pullback, have we?

David Chidester

No.

Nat Schindler – Merrill Lynch

Now, those numbers you mean in users or revenue?

Patrick Byrne

Revenue.

Nat Schindler – Merrill Lynch

Revenue, okay, good. Always want to check. And then the other question I have and I have asked you this before and I guess this quarter even more highlighted. What’s the advantage of staying in the direct business?

Patrick Byrne

Well, it’s a good question. And we are – we have substituted information for capital throughout the supply chains. You have to be in the direct business to import, and some of the stuff we do is importing. We have to be in the direct business in the sense that we handle all the returns now. And we process them and we put those up on the site, so we need that direct business. What is our direct business showing up on a GAAP basis, David, as a percentage of sales?

David Chidester

It’s about 21%.

Nat Schindler – Merrill Lynch

Yes.

Patrick Byrne

We are not tied completely to the direct business, but if anything what we think is happening is we are learning a lot with our partners. And maybe there is a way we can work with our partners that harnesses our physical assets such as they are, and let’s them do what they do very well, which is buy. So we are not ready to pull the plug on the direct business and if anything there is some reason to think it’s going to come charging back, especially now. This is the time, this is probably the best buying opportunities we’ve seen since we went public.

Nat Schindler – Merrill Lynch

So, are you going to be doing something with your customers to leverage your physical assets? Is that similar to fulfillment by Amazon?

Patrick Byrne

With our partners, yes, it could be something like that.

Nat Schindler – Merrill Lynch

Also, what percentage then of your direct business is reselling returns?

Patrick Byrne

Got to be about a quarter of it. Isn’t it Dave?

David Chidester

I don’t think it’s quite that high.

Nat Schindler – Merrill Lynch

Okay. So I mean but, you would always need to have a few percentage of your total revenue would have to be indirect just to resell the returns that you get back on the system?

Patrick Byrne

Correct.

David Chidester

But I think we’ve also become much more focused on getting product based on our customers’ demand and not just on what products are out there. And so I think having the ability to go to buy direct or buy through partners just enables us to get the products that we want to get for our customers. And it allows us to keep certain categories, keep product in those categories at all times rather than potentially having it drop off and come back on. And so, we kind of look at the whole business together and say, how do we make sure we have the products that our customers want. And I think it just gives us more ability and eventually over time it will tell whether we need the direct business or not, but the economics will decide that.

Patrick Byrne

We have a great relationship with our partners and we have spent a lot of time, you have got to talk to some of our partners and what they say, who have worked with us and worked with other opportunities. I mean we really do some special things, but I think it also keeps the relationship honest for us to have at least the potential to be going out and buying ourselves. Just keeps the relationship a lot more on an even keel. We don’t have any ego about the direct business. We had actually thought at the beginning of this year that that this might be the year of the core because we had learned so much that we could go out and buy. And the way we want to buy is not to cut our partners out, but there’s ways of involving them. But core hasn’t come charging back. It’s really because I think we haven’t completely dialed in a couple of things that we will need to dial in before we see it come charging backWe have a very full team working on just that issue. And if it works, we might be able to get , we think, if that all plays out as we hope; it may come back and in a very big way. So anyway, that’s my answer. Anything else?

Nat Schindler – Merrill Lynch

No, I think that gets me. Thanks.

Patrick Byrne

Thank you. Scott Devitt – I was just handed a list – Scott Devitt and then Don LaCava. First, Scott Devitt. So I will say Scott, Dom, Andrew Watts, and then Mike (inaudible). So Scott Devitt, please.

Scott Devitt – Stifel Nicolaus & Company

Hey, Patrick, how are you?

Patrick Byrne

Hi.

Scott Devitt – Stifel Nicolaus & Company

So the – I guess if you exited the direct business your inventory turns would go up even more, but that’s not my question. The question is just around the revenue growth rate, which was 27% in the first half, and you are suggesting 17% in the back half and I want to get my hands around just how much of that is the comps. It seems like you are explaining the vast majority of it away in the comparables to last year. Is there anything else in terms of your thought process or could you maybe handicap how much is comps, how much is conservatism around the economy?

Patrick Byrne

I think it’s probably about 50/50. You know and it looks, yes, it looks – I think that the chances are probably 5% to 10%, well, 10% say that we would do worse than 17% over the second half. But there is a chance, I just have to be conservative about the economy, I think we are really entering the big black hole. So, 50/50.

Scott Devitt – Stifel Nicolaus & Company

And then just two other ones if I could. Customer acquisition cost was up 37% year-over-year. So, is it getting more difficult to acquire? Is that a component of as you dial back sales and marketing that you are assuming the revenue growth decelerates?

Patrick Byrne

Well, different issues. The 37% is a function of partially we tried this whole new and relatively expensive area of marketing that we did sort of what might have been a one- or two-year program we compressed into six months. So that drove it up, but I think that that reverses itself just because we cut that additional spending.

Scott Devitt – Stifel Nicolaus & Company

And then—

Patrick Byrne

We have already cut that in July.

Scott Devitt – Stifel Nicolaus & Company

And finally, the SKUs, I think it’s a trailing basis or some metric you have, increased pretty significantly, the non-media SKUs on the site. And third party was up 41% in the quarter. I know historicallyyour third-party business is populated mostly by direct manufacturers selling on the site, but you also do offer services to eBay PowerSellers. Could you characterize the incremental growth? Is it coming from your traditional partners? Are you seeing more PowerSellers testing the marketplace? And that’s all I had. Thanks a lot.

Patrick Byrne

Thank you. We are seeing that it’s not only coming from manufacturers. There are we think of as distributors that and they can be eBay PowerSellers. They can just be people within the normal retail supply chain. And a lot of the growth is coming from that level. Dave, do you want to add anything, or Jonathan?

David Chidester

Not anything. That’s correct.

Patrick Byrne

Okay.

Scott Devitt – Stifel Nicolaus & Company

So that level being the distributors not eBay PowerSellers?

Patrick Byrne

No, distributors, but in which we include eBay PowerSellers.

Scott Devitt – Stifel Nicolaus & Company

Okay.

Patrick Byrne

But as opposed to manufacturers. But you will be hearing about some new partnerships opening up with manufacturers and well-known distributors this quarter.

David Chidester

And a lot of our existing partners continue to put more and more SKUs up.

Patrick Byrne

Yes, that’s –well I should not gloss over that. We are giving a lot of information to our partners to help them buy better and they are great buyers and so a lot of our partners are really expanding their SKUs. And maybe there are SKUs in an area, if they buy this type of apparel and they are not, but there is another corner of apparel we have never been in before. Maybe instead of going in and finding a new partner for that area we are finding, we talk to new partners in adjacent areas who say, “Yes, I can handle some of that.” And they are expanding and we give them a lot of information and help to do that.

Scott Devitt – Stifel Nicolaus & Company

Thanks.

Patrick Byrne

Thank you, Scott. Let’s go to Dom Lacava from Canaccord.

Dom Lacava – Canaccord Adams

Okay. Can you tell us what percentage – you may have already answered this, but just to come out of it a different way, what percentage of your third-party or your fulfillment partner revenue is from liquidators? You know, are you seeing third-party partners kind of put in non-liquidation product into the channel. Just want to get a sense as to how that’s shaking up from a mix perspective?

Patrick Byrne

Well, I don’t think we break it down like that. We try to not be too – we try to be somewhat discrete about our partnerships. Dave, you talk to the world more than I. What do you say? Dave?

David Chidester

Oh, sorry, sorry, had my mute on. We haven’t talked about that historically and giving that breakout. I mean there is no specific strategy on that as a category.

Patrick Byrne

There is also not a clean demarcation between the junior partners, it can be a distributor in one quarter and they are liquidating in the next or such. So—

David Chidester

Or it can be between products. They have some products you would call liquidation, some you wouldn’t.

Patrick Byrne

Correct.

Dom Lacava – Canaccord Adams

Just trying to get a sense as to is pricing coming up in general. Like if it’s less liquidation, and more non-liquidation, pricing could be coming up on a blended perspective. Just trying to get a sense as to what’s happening there.

Patrick Byrne

I don’t think I can answer you of the top.

Dom Lacava – Canaccord Adams

Okay, okay, fair enough. And then on the New York state tax situation, can you give us any color on how business trended once the New York based affiliates were phased out or just any color around that situation at all?

Patrick Byrne

Sure. New York represents about 10% of the country and so you can assume that our business is spread geographically like that. And affiliate business is, let’s say, in the range of 10% to 15% of our total sales. And you can put those numbers together and sort of understand where about New York affiliate business is. And it was, I think it actually was less than 1% is what it came to. I wanted to mention, Jonathan wants to hop on and talk to you, I understand there has been developments this week. Why don’t you do that and come back to me. I will have something else to add.

Jonathan Johnson

You know, one thing I want to comment is turning off a New York affiliate doesn’t necessarily mean turning off New York sale. I mean if some guy has a blog and he runs it out of Long Island and we turn him off. That doesn’t mean sales are necessarily New York or otherwise. So, I don’t think we have seen a big effect in turning off those affiliates.

Just commenting on the New York tax law situation, this week the New York State Senate introduced the bill and then very next day voted unanimously to approve that bill, which would repeal the law that we have challenged in court. So, it’s gotten through one house of the New York legislature. We are waiting to see what happens in the assembly. So, we expect the things to happen.

Dom Lacava – Canaccord Adams

Yes. Do you think the governor will sign that?

Patrick Byrne

Who knows what the governor will do. But it’s a bad law. It’s an unconstitutional law. They would do well, rather than to fight it out lose in court, to just get it repealed.

Patrick Byrne

The other thing I was going to say is we have formally, we have 3,400 affiliates, we had less than 200 – 3,400 affiliates in New York that we cut ties with, sadly. Less than 200 of them were delivering substantial sales. People brag about having an affiliate network of 50,000 affiliates, but in that 50,000 affiliates there is (inaudible) scenario’s the mathematical term. There is going to be a 1,000. It’s not 80%, 20%, it’s 90%, 95% or something or even worse. I think and this is non-material, so if I am wrong on this, we should not have to issue a release. I did a calculation before when we made this decision; the New York affiliates were responsible for in the order of 0.6% of our sales. So maybe a few tenths, plus or minus. But that’s about where they are. So, ending that relationship in return for not having to surcharge sales tax on, say, about or near 10% of our sales was the right trade-off.

Okay, do you have anything else, sir?

Dom Lacava – Canaccord Adams

Just one question. Any update on the international efforts?

Patrick Byrne

Sure. It’s one of the reasons I’d say there is a wild card. I know it’s primarily from an analyst point of view to have someone saying well we could, 17% looks good. Well, but we might grow to 35% to 40%. We are going to have international. We will be turning on, scheduled to turn on, no reason I can’t say that the date, it’s August 30th I think or last few days of August now as these things go. Actually this is being run beautifully (inaudible) Jack Bailey inside the company, and Jacob Hawkins who you remember from marketing, and this has been developed right on track. It’s such a difference. We now have the resources to develop programs where we used to look at this laundry list of things we wanted to do, and we looked at a very short list of resources, and it was just with perpetual triage. We now have a really good team. We form teams that we dedicate to different projects. There has been a good team on this. They are hitting all their marks and we hope to get live in the last few days of August, and that’s 34 countries.

Mentally, I’ve said, well, that means increased sales, what,3% to 5%? But with the decline of the dollar, I was actually just overseas. Everybody knows about us. I am surprised at how much of a brand we have internationally given that we don’t sell, but people at least know about us and ask when we are going to start sellinginternationally. So, what does it actually do? Like I say, I think in terms of 2%, 3%, 5%, it may add to sales, but who knows it may do something more significant.

Dom Lacava – Canaccord Adams

Okay. And the last question is I guess in light of eBay results, can you talk a little about your Cars business, how that’s trending and Auctions? And that’s it from me.

Patrick Byrne

Okay. Well, both Cars and Auctions are doing well. They are profitable on an internal basis. That means with all their costs including marketing and all the people who work there. We don’t charge them for the floor space. But I think they are two nice businesses, and I think in the case of each of them there is something big we can do. It’s a different thing in each case. In the case of Cars, in the case Auctions there is something I want to do that I think may help it turn into a significantly better business. And within the case of Cars, we are renegotiating some of our advertising relationships, and seeing that we can do much better there as well. So, we are optimistic but they are both fine little businesses now.

We launched Homes this quarter, and I think we have a really good Home site. You look at our Home site and you use the graph. You use that graph it gives a scatter plot of all the different homes just like we do in Cars. You can find great deals quickly. I have been looking for a home. And it’s really some technology that differentiates us. So, I have hopes for both of those. Anyway, I will stop there.

Dom Lacava – Canaccord Adams

Okay, that’s it from me. Thanks, guys.

Patrick Byrne

Thank you. A point, those were developed under the tutelage of Jacob Hawkins. He has done a fine job sort of nurturing these new jobs, these new businesses to life, and he reports to James Joyce, who is a great mentor for him.

Andrew Watts, please, Oaktree Capital.

Andrew Watts – Oaktree Capital

Hi, good morning.

Patrick Byrne

Good morning.

Andrew Watts – Oaktree Capital

I just wanted to kind of talk about the stock repurchase and your use of capital there and particularly in light of the fact you know you do have obviously some public debt outstanding as well. What are your thoughts as far as equity repurchase versus debt repurchase, so that’s probably trading at a significant discount to book value versus the stock trading at significant premium to book value? And what’s your decision when you look at those two alternatives?

Patrick Byrne

You know, it’s funny you say that! I will mention that I just – I mentioned that I just noticed this trade developing in the convert, where it’s basically trading at $0.70 on the dollar with three and a half years left and its price to yield, what is it, 3.75? I mean its coupon is 3.75 and so if you do the math that I assume so I think we should. We could pay off completely; buy something for $0.70 and pays off $1 in three years, that’s three and a half years, that’s 10.4% plus the 3.75% coupon. You got a 14.15% return plus a lottery ticket. So, I see that trade, in fact I have just started actually talking with Jonathan and Dave Chidester about it. I see that trade and I have been scratching my head wondering that even if we did go back into repurchasing would it be smarter to repurchase something with sort of a guarantee 14% plus return with a lottery ticket stapled to it? We haven’t really done the analysis that we’d have to do, but yes Dave or I mean Andrew, please give me your thoughts.?

Andrew Watts – Oaktree Capital

Well, I was speaking to full disclosure. We are holders of the converts and I am one of those guys who I think equity repurchases to a large degree are one of those emperor with no clothes kind of situations where a lot of companies have purchased huge amounts of stock at a huge premium to book value, which I see as really destroying shareholder value, except for the guys who happen to sell at that particular point. So, I am one of those guys who, obviously I have an interest in your looking at this security. But I think just think from a balance sheet management standpoint and a capital management standpoint that it makes so much more sense to buy debt trading at a discount to book than equity trading at a significant premium to book, even for shareholders. And you know building shareholder value from underneath rather than somehow distributing it but only doing it to the people who are selling the stock. I have just seen too many companies that have kind of drank the Kool-Aid on the equity buyback and as a result really trash their balance sheets by purchasing stock at just ridiculous premiums to book and the mathematics to me are pretty simple. I think there are times when it does make sense, if you have a high growth high cash flow business, but there aren’t a lot of businesses out there where that kind of decision makes sense to me.

Patrick Byrne

Well what you are saying doesn’t fall on deaf ears fears. There was a point three or four months ago we were trading at $8 and something.

And I was looking at that. and I think we had an enterprise value of 100 we have an idea of what our cash flow looks like over the next couple of years and we can sort of assume even 20% or 25% growth in the top line and some marketing improvements. And that’s just looked like a very low multiple of future cash flows to us.

Andrew Watts – Oaktree Capital

Well, obviously, so far you guys have been proven right on that.

Patrick Byrne

Well, it’s better to be lucky than smart. But I am not arguing with you. In fact, the virtues of the covert buyback, it’s a lot easier to do the equity buyback, the convert trades by appointment only, and it’s like getting a reservation at French laundry(inaudible) I mean the convert just never trades, Where is it trading now?

Andrew Watts – Oaktree Capital

I think you’re about right, somewhere around 70s, it’s probably about the right level for us.

Patrick Byrne

That’s pretty attractive to me. That’s pretty attractive to me. I’ve actually have been just recently raising this issue here that we should do the analysis of the virtues of buying. Where would we buy stock back at, and where would the convert be.

Andrew Watts – Oaktree Capital

Great minds think alike again.

David Chidester

It becomes more, it’s obviously a great investment and if we had lot of excess cash and I think it would be a no-brainer. I think the issue is more just having working capital at this point and if we get the business spinning up and generating more working capital, definitely it’s something, it’s clearly a great investment.

Andrew Watts – Oaktree Capital

To me it’s not so much that you should buy the bond where at these levels, if you are going to buy something it seems much more to make much more sense to buy them.

David Chidester

Right. Completely agree.

Patrick Byrne

What do you think of the other argument, Andrew if we as a country are entering an economic dark ages, what do you think of the prudence on using our balance sheet or using cash to buy more debt? Who knows what the next couple of year’s looks like?

Andrew Watts – Oaktree Capital

I think you make that decision as far as where you want to allocate your investment. All I am arguing is if your choice is A buy back stock, or B buy back debt, it makes so much more sense to do it on the debt side is what I am arguing. In particularly, even more so if you are entering a dark period you certainly don’t want to take away permanent capital when you are going to have to pay these bonds back in little over three years.

Patrick Byrne

That’s actually a nice additional point. That’s great thinking, Andrew, and thank you. I tell you what, if anybody is out there who is interested in selling their converts at 70, please call collect and we can have a conversation.

Did I just violate some Federal regulations on that?

Jonathan Johnson

No, we haven’t really agreed to do anything, we will certainly take calls collect.

Patrick Byrne

Thank you, Andrew. And Michael Ongey from? I am sorry, Michael.

Michael Ongey – Ibis Managment

Ibis Management.

Patrick Byrne

Ibis Management. Okay, I am sorry, I thought that was an abbreviation. I see your name. Anyway, go ahead, Michael.

Michael Ongey – Ibis Managment

Yes, thanks. Regarding your international business, what are your goals in terms of revenue mix between fulfillment and direct?

Patrick Byrne

It’s a good question, actually what I want to say is we are agnostic on that as well, we are agnostic ona lot of things, but we are indifferent. The way that this is structured with our partner, which has been announced E4X, which is a Pitney Bowes company or a Pitney Bowes related company, we know is that we are shipping orders to warehouse in New Jersey, and it doesn’t matter to us that they are taking it from there. So the whole partner versus core thing doesn’t make a difference on the international side; it’s just going to operationally to us look like one big customer in New Jersey.

Michael Ongey – Ibis Managment

Yes, it’s all about what types of products can we sell in international and which we can’t, and that’s what will drive it.

Patrick Byrne

Yes, products we’re shipping that are a larger percentage of the sales price are products that are going to not work as well internationally.

Michael Ongey – Ibis Managment

Okay.

Patrick Byrne

And of course anything that’s LTL, Less-than-Load, meaning it can’t be shipped by UPS. It shipped on a pallet and a truck. Sofas aren’t going to work too well internationally.

Michael Ongey – Ibis Managment

Okay, great. My second question is I think you guys try to do something with Facebook social network type of advertising before and I saw that’s Sears is trying to do something like that as well. I actually for my hobby actually develop a lot of Facebook apps last year when the APIs came out, and I thought this was really a powerful viral medium, and I just thought if you had looked into that and if you haven’t maybe it’s something that might be really good as far as arbitraging the opportunities in the internet space. I am not pitching my apps, I am just saying I just saw there was an opportunity that it seems like it’s really viral and grew really fast.

Patrick Byrne

Please do pitch your apps and please if you have some apps or even some more thought that you want to share with me please just get in touch with me directly. You know, my e-mail is patrick@overstock.com. The social medium I said somewhere, it’s like, Bam Bam, Barney Rubble, and Flintstones, it’s this very powerful infant that doesn’t know its own strength and people don’t really know what to do with it. Facebook is unbelievably viral, it’s just grows and grows. There is the take on social media that people haven’t figured out quite how to monetize it yet, and it is true from investor village, which has this tremendous traffic, but the word was from people it was hard to get people to buy. They go and check the horoscopes and such, and the same thing seems to be the case for now in social media. I don’t think it’s going to stay that way. I think people getting the kind of traffic, they are getting will figure out at some point how to monetize it. I think those are extraordinary companies. We did work with them in the fall and we developed a program, I think it was called Lamp Light or, Dave, do you remember the name of that program?

Michael Ongey – Ibis Management

Beacon, right.

Patrick Byrne

When you bought something, if you opted in into this program on our site and on Facebook and said that you were cool with this, it would be tell your friends, hey Michael just bought a TV, this TV at Overstock. Well there was a big privacy explosion, and we thought it was okay even though because people were warned and had to check something and all that stuff. Anyway, it wasn’t okay to Facebook users and there was a bit of a scuffle about it around Thanksgiving, and so we went off until Facebook sort of figured it out, what the rules had to be to satisfy their people. We’re open to doing more. And I’m with you that I think social media is extraordinary and it’s going to I think it’s going to get monetized at some point, but I don’t’ know if you have any ideas on that and want to talk about it further I’d love to call collect.

Michael Ongey – Ibis Managment

All right, we’ll do, thanks.

Patrick Byrne

Great. We are also doing some stuff in social media ourselves, Oh somebody was asking about that; somebody out there was oh muse and this community we started. We started it, and it’s just been nascent, it’s Beta and we’ve been working on a major revision. I think you can be seeing that go live before the month is over. So keep tabs on our community tab.

Michael Ongey – Ibis Managment

Oh, great. Thank you.

Patrick Byrne

Thank you. Okay. It is now 10:13. Thanks everybody for attending. And we look forward to seeing you this summer if you come by and if not, talking to you in October. Dave, anything to add?

David Chidester

No.

Patrick Byrne

Jonathan?

Jonathan Johnson

No. Great, thank you.

Patrick Byrne

Good day. Bye-bye.

Operator

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

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Source: Overstock.com, Inc. Q2 2008 Earnings Call Transcript
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