Overstock is a low-margin business - is that a shock? (4Q04 earnings)

Jan.28.05 | About: Overstock.com, Inc. (OSTK)

Overstock.com reported Q4 results and its stock got whacked by about 12% in late trading. First a quick overview of the quarter (the conference call is tomorrow morning), then a couple of comments about Overstock's business and why the stock got hit.

Q4 results (taken verbatim from the press release)

  • Total revenue: $221.3 million, up 80% versus prior year
  • Gross bookings (excluding auctions): $237.0 million, up 82% versus prior year
  • B2C gross bookings: $233.4 million, up 95% versus prior year
  • Gross margins: 15.2% versus 13.3% in Q3 and 9.6% in Q4 2003
  • Net income: $2.5 million or $0.12 diluted earnings per share
  • Cash flow from operations: $37.0 million

Together with these results, Overstocks' press release contains a long, chatty letter from CEO Patrick Byrne. And here's the crunch: in the middle of the letter, he writes:

Margins -- Tightening our logistics costs and better merchandise buying generated a steady rise in gross margins from Q4 2003 - Q4 2004: 9.6%, 10.3%, 11.3%, 13.3%, 15.2%, respectively. I noted in Q1 that better logistics would allow us to shave 400 basis points out of our costs. Since then we improved margins 560 basis points: somewhat less than 100 were the result of scale, and the other 460+ were from good management on the part of my colleagues. Here is the punch-line: I now see another 250 basis points we can squeeze out of logistics, but these are, I fear, the last. Furthermore, shareholders are not going to see them: as in the coming quarters we scrape these savings out of the system, we will in one way or another pass them on to the consumer. Thus you are unlikely to see our margins rise above 15%, excluding the effects of auction and travel. I think 15% is the right level for our margins as it will provide great prices for our customers and a strong return to you, Overstock's owners.

Shareholders clearly didn't like this. Overstock's dramatic revenue growth was likely already priced in to the stock due to the publication of traffic data by comScore and Majestic Research in late December and early January. So the key incremental news item was Byrne's statement that "you are unlikely to see our margins rise above 15%". Given gross margins of 15.2% in Q4, that implies that not only is there little operating leverage in the model (at least in terms of gross margins), but that gross margins will actually
fall. While Q4 is seasonally strong for retail and gross margins would usually fall in Q1, Byrne seemed to say that 15% is the upper limit for gross margins permanently.

Quick comment: Byrne's suggestion that further cost improvements will be passed on to customers rather than shareholders shouldn't come as a shock:

  • Overstock, by its very name, is positioned as a low-cost brand. Customer loyalty will depend on Overstock maintaining price leadership, and seach engines and comparison shopping engines will make it easy for customers to check comparative prices.
  • With customers arriving via search engines and comparison shopping engines, Overstock is exposed to rising pay-per-click (NASDAQ:PPC) ad prices.
  • Offline retailers are increasingly focusing on their online channels. Unlike the pure-play online retailers, they are able to drive traffic to their web sites from their stores and circulars. With relatively higher marketing costs than its multi-channel rivals, Overstock needs to offer compelling prices to attract customers.

Key question for investors in e-tailers: Overstock fulfilled $89.6 million of revenue itself, and used a partner to fulfil $131.7 million. Which begs the question: will Overstock gain from using a specialized fulfilment partner, or will it find it harder to compete as it has to pay enough margin to the fulfilment partner for that company to be profitable?

We'll hear a lot more about this issue with the IPO of Buy.com, which uses Ingram Micro for most of its fulfilment and claims that it gets more operating and financial leverage that way. No doubt Amazon, which has specialized in low-cost fulfilment, would disagree.

One year chart of OSTK below.