When Overstock.com (NASDAQ:OSTK) was first hatched in 1999, the concept of online shopping was in its infancy. Overstock came into the world with a clear mission to serve a unique niche using an identifiable and common sense brand. The firm aimed to become "the premier company selling excess inventory through the Internet" (from Overstock.com corporate website). The company successfully exploited its niche and grew quickly for years.
With time, however, competitors also grew and began to encroach on Overstock's space. Threats came from all directions - mass merchandise retailers Amazon (NASDAQ:AMZN) and EBAY (NASDAQ:EBAY) were willing to sell surplus inventory and just about anything else. Niche sites that might focus on a single category were gaining popularity. Some of Overstock's retailer "partners" decided to go directly to the consumer using their own sites. Super discounter "no-name" sites popped up with increasing frequency.
Overstock realized that in the world of retailing, branding meant everything. Over the years they had built a brand that mattered, but they risked losing relevance because the company was losing share quickly. Management realized that the only way to survive in such a competitive space was to leverage the brand to grow outside their traditional business. Failing this, the brand would slowly lose importance and the business would be strangled.
Overstock began groping for new strategies. The company migrated to become a mass merchant, emulating Amazon and expanding to sell non-liquidation items from a larger base of categories. They rebranded to O.co, and put their name on Oakland's coliseum. They started services to sell autos, real estate, travel, and insurance. They even began an online auction-style marketplace and a private sale site.
Yet Overstock seemed to be adding to its difficulties with each of these endeavors. Either Overstock was too late to the game to win with each new strategy, was not differentiated in its offerings, or just failed to execute. At any rate, the costs of running these efforts began to weigh on results as Overstock's top line continued to lag industry growth, so the company was forced to abandon O.co, shutter the marketplace, private sale, and real estate businesses. The other businesses survive today but haven't made a meaningful contribution to growth.
While this picture of a stalling business that has lost its way sounds quite hopeless, there is obviously some hope in Overstock's stock these days. OSTK has rallied over 110 percent in the last five months and is now trading at a whopping 31x trailing twelve months free cash flow of $8 million. Not bad for a company that's not growing, is only barely and occasionally profitable, and whose balance sheet is on life support (witness the working capital deficit of $7mn).
The Double Super-Secret Project
So what gives? On the last couple of conference calls Overstock's CEO, Patrick Byrne, has alluded to a secret project that marketing guru Stormy Simon has been managing. We know only that it involves partners and that "it's working beautifully" (Overstock's 1Q conference call). I'm taking an educated guess here, but I think I know what the skunkworks are all about. You ready? Here goes. Overstock is selling its merchandise through a third party marketplace - Sears.com (NASDAQ:SHLD)!
While this isn't innovative or revolutionary in any way, it can add to top line growth and to gross margin dollars, and that is a reward that investors can appreciate. The company has been rumored to be touting this business internally as one that is on track to generating seven figures in revenue annually. And if Overstock is successful with Sears, why can't they expand to Wal-Mart (NYSE:WMT), Target (NYSE:TGT), and heck, even Amazon! Perhaps Overstock can become a consistently profitable growth business at last?
The Brute Force of Reality
The market clearly has bought into this line of thinking, but as I ponder the ramifications of the new strategy it brings a starkly different image to mind. Patrick Byrne, Overstock's CEO, is a fisherman lost at sea and dying of thirst. He has tried every survival trick in the book, but he has reached the end of his rope. With all that water around him he finally yields to temptation and gulps down the briny seawater, temporarily satisfying his need for hydration but accelerating a disastrous end.
Let me explain. Despite all of the company's travails over the years, Overstock has resisted the temptation of earning a few extra bucks by subordinating its brand in a large retailer's marketplace. The opportunity has always been available; in fact many of Overstock's lower-end competitors have been using the marketplace concept to juice sales for years. Yet Overstock had always appreciated the value of its brand, and understood it to be the single most important element that separated it from all the me-too discount websites that came and went like fads.
With its business failing badly last year, however, Overstock became terribly desperate. It saw Sears' Marketplace as a lifeline and grabbed it. As such, Overstock is now outsourcing branding to Sears. Sears is gathering the eyeballs in this endeavor and Overstock will serve as the processor and logistics manager. It has disaggregated what amounts to the most valuable portion of its business from the value chain, handing it to someone else, accepting lower margins in what is already a very tight margin business. Overstock is becoming a middle-man to the middle-man. It is debasing its brand for a short-term reprieve in an otherwise declining business, but in doing so it has pushed itself deeper into trouble.
Debasing and disaggregating? Those are big words and complicated thoughts. This is a pretty simple idea that Overstock is pursuing and it's generating profits - how can that be a bad thing? First, understand that Overstock's fulfillment partners are the lifeblood of its business. These are the manufacturers and merchants who sell their goods on Overstock's site. These partners, however, typically sell their products on many other retailers' websites, and Overstock can lose them or lose clout with them. One of the issues with OSTK's new strategy is that as Overstock sells more of its partner's goods on Sears' site and fewer directly on Overstock's site, Overstock means less and less to these fulfillment partners. If the partners are doing well with Sears, these fulfillment partners can simply cut Overstock out completely and share Overstock's margin with Sears. They don't lose a thing as Sears will process payments and handle logistics just as Overstock had. Meanwhile, Overstock loses share to Sears and its traffic continues to decline (this may happen even if it keeps the fulfillment partner - more on this later.)
If you don't believe that selling as a third party on a large retailer's marketplace can be dangerous then read this or this. Or you can visit an open online marketplace (as opposed to a more exclusive one that is set up with a few select retailers) such as the one hosted by Amazon, Ebay, or Sears.com, and you'll see that branded retailers are conspicuous in their absence. Instead you find names like Cymax, Walts.com, Pineapple Sales, and Unbeatablesale.com.
A quality, branded retailer won't sell in an open marketplace because the retailers that run these marketplaces are in the driver's seat. If Overstock sells something very well on their site, they have all the details instantly and can either approach OSTK's supplier directly, or find a similar product from another manufacturer so that they can capture those sales directly. Once the marketplace's owner has the product, they put it front and center on the site, and Overstock sees its business cut by 80%. This dynamic acts as a natural choke on marketplace sales volumes for third party vendors like OSTK.
There are other dangers to selling as a third party in a marketplace. In addition to losing control of sales and supplier data, there's the potential for customer confusion around returns and branding. There's also potential for customer disappointment due to poor inventory coordination. These factors as well as the brand degradation are enough to keep recognizable brands from these strategies.
Becoming a marketplace seller instantly enters Overstock into a highly commoditized business. The discussion with fulfillment partners moves from one in which the company could say "we expose your goods to an audience that's unique to Overstock" to a conversation about the sheer number of eyeballs and the price per eyeball. And while Overstock may have a lot of eyeballs to sell if it creates a network of marketplaces, it won't be much different from any of the hundreds of retailers doing the same thing. That means that it won't have much in the way of margins, and this company is starved for margin.
Perhaps most important, the new channel is likely to accelerate the decline in customers using Overstock's branded website. Brand degradation leads to lower customer loyalty and orders. Yet there's another angle at work as well. Believe it or not, Sears.com, is the 8th largest retailer on the Internet (see here). There's a strong likelihood that many of Overstock's customers are also customers of such a large company. These overlapping customers will no longer need to go to Overstock to do their shopping. They can get everything they used to get on Overstock from Sears.com.
The new arrangement is convenient for the overlapping customer base, but not so convenient for OSTK. Overstock will suffer a double whammy as it makes less profit on sales run through Sears, meanwhile it also loses traffic that would have otherwise gone directly to Overstock.com. This creates a downward spiral as less traffic leads to fewer fulfillment partners which leads to even less traffic. Open marketplaces are the thirst quenching seawater that struggling brands gulp down on their way to the retail graveyard.
Who Cares What the Competition is Doing?
There's a revealing backstory behind Overstock's new strategy. It turns out that its successful upstart competitor, Wayfair, has been exploiting these third party marketplace relationships for a couple years while taking share from Overstock. Wayfair (a private company once known as CSN Stores that did over $500mn in sales last year) grew from a group of hundreds of niche ecommerce sites to a single monster site that recently consolidated these hundreds of niche businesses into one web offering. To help transition to a single site model, and help get the name "Wayfair" recognized, the company partnered with many high profile web retailers. They sell on Amazon, Barnes and Noble (NYSE:BKS), Wal-Mart , Sears, Tesco (TSCO.L), to name a few. The strategy of selling through third party marketplaces isn't nearly as dangerous to Wayfair, the company has no brand image so it has nothing to lose, it has very little traffic on its site, its business model sources from very small, niche suppliers who would have difficulty going direct to a large retailer, and it is likely in better financial shape than Overstock having just received a healthy slug of venture backing.
Where's the Beef?
How does the Sears.com marketplace partnership work for Overstock? Go to Sears' homepage and you won't see any mention of Overstock or any other partner for that matter, all you see are goods sold by Sears. Drill down in a category where OSTK has a presence and look at merchandise. You still won't see anything from Overstock. If you page through three or four pages deep you finally start to find some partner merchandise. You'll find Wayfair, OJ Commerce, FOAstore, Hold N' Storage, Shopzeus, and sure enough, something from Overstock. It's a crowded marketplace with all kinds of "no-name" vendors begging for your business.
As one of what appears to be hundreds of vendors buried deep within Sears.com, how is Overstock going to derive significant revenues from this relationship? Well, Sears.com does a lot of business, and some of it will trickle down to Overstock. How much? Your guess is as good as mine, but management is rumored to be talking up "six or seven figures" in revenue from this relationship.
Let's give management the benefit of doubt and assume that the Sears business becomes solidly eight figures. What would $20 million in annual sales through Sears mean to OSTK? I spoke with an ecommerce analyst who estimated the partner business would carry gross margins in the eleven percent range. Overstock's non-partner fulfillment business margins hover around 19 percent. For my model I'm assuming that margins are around 13.75 percent on the Sears business - 70% of their normal margin. I'm also being fairly generous in assuming that 85% of the gross margin dollars from Sears sales make it to the operating line. Overstock will have some variable costs to support listing items and managing logistics but much of the infrastructure to support this business is already present. Thus $20mn in sales would yield around $0.07 in earnings annually after a 30% tax hit ((20*.1375*.85*.70(tax))/24.3(shares)).
Yet to fully depict the impact of the relationship we need to account for the negative ramifications it has on Overstock's core business. While it's difficult to immediately quantify the impact of brand degradation on this business, we can look at traffic trends over the last three months to see if there has been any short-term impact. Alexa data shows that Overstock's traffic deterioration has accelerated in the last three months, with pageviews declining 11 percent sequentially over the period. There could be other reasons for this decline, and mix trends and conversion ratios can throw the analysis off. Nonetheless, the metric generally serves as a good directional gauge of business and it doesn't look promising.
What does all of this mean for the stock? Overstock needs roughly six percent sequential growth in revenues to hit estimates for the quarter. If the Sears business contributes $5mn in revenue, that would offset around two percent of traditional business decline on the top line (with light margin business). With traffic down approximately 11 percent sequentially it seems unlikely that Overstock will hit Street top line targets. Since it is the higher margin business that is lagging, bottom line performance may also disappoint. These trends don't signal very good things for OSTK's all-important fourth quarter either. It wouldn't appear that Overstock's marketplace strategy is creating enough revenue to save the day.
If Overstock's dramatic share price appreciation has anything to do with its Sears partnership (or speculation about other partners) it is a fairly large misread by the market. The market is overestimating the returns this business can bring while failing to recognize the risks inherent in the new strategy. The market also seems to be ignoring the declining popularity of Overstock's web site. Overstock is throwing in the towel on its brand which will ultimately have investors throwing in the towel on its stock.
Another theory regarding OSTK's rapid ascent has to do with the fact that the company isn't collecting sales taxes from customers in many of the states where Amazon and others are being forced to do so. I don't think this is a big factor. A recent large survey showed that in practice tax collection isn't altering consumer's online shopping habits. Also, OSTK hasn't seen a bump in traffic as other retailers have begun collecting taxes. Further, its competitors who aren't collecting taxes have not seen their stock prices appreciate to the extent that Overstock's have.