Overstock.com Inc. Q1 2006 Earnings Conference Call Transcript (OSTK)

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 |  About: Overstock.com, Inc. (OSTK)
by: SA Transcripts

Overstock.com Inc. (NASDAQ:OSTK)

Q1 2006 Earnings Conference Call

April 28 2006, 11:00 AM EST

Executives

Patrick Byrne - Chief Executive Officer

David Chidester - Senior Vice-President of Finance

Analysts

Aaron Kessler - Piper Jaffray

Doug Anmuth - Lehman Brothers

Scott Devitt - Stifel Nicolaus

Frank Gristina of Avondale Partners

Operator

Good day, ladies and gentlemen. Thank you for your patience, and welcome to the First Quarter 2006 Overstock.com Incorporated Earnings Conference Call. My name is Bill and I’ll be your conference coordinator for today. At this time, all participants are in a listen-only mode. However, we will be facilitating a question and answer session towards the end of today’s conference. If at any time during the conference today you require assistance, please key star, followed by zero, and an operator will be happy to assist you. As a reminder, today’s conference is being recorded for replay purposes. I would not like to turn the conference over to your host for today’s presentation, Mr. David Chidester, Senior Vice-President of Finance. Please proceed.

David Chidester

Good morning, and welcome to Overstock.com’s first quarter 2006 conference call. Participating with me on the call today is Dr. Patrick Byrne, Chairman and CEO of Overstock.com. Please keep in mind that the following discussion and the responses to your questions reflects management’s views as of today, April 28, 2006 only. As you listen to the call, I encourage you to have our press release in front of you, since our financial results, detailed commentary, and the 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, in 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 10K, 10Q, 8K, and F1.

I will now turn the call over to Patrick.

Patrick Byrne

Thank you, David. I’m going to take -- there were 40 people on the call, but they said several hundred trying to log in, and rather than delay, we’ll try to start and I’ll just spend the first few minutes talking about this crusade, which is I know something people always ask me about privately, not publicly. That will give time for the operators to log in what I understand is a very big queue.

So I’ll tell you my thoughts on this. One is I know that some will say this crusade is a betrayal of my responsibilities as CEO. I could say that I’m certain that it isn’t, and I would be almost completely truthful. I could say that the crusade doesn’t interfere with my duties as a CEO. That would be largely truthful. But the simple truth is this is -- I think we in the financial community are living over a deep fissure. I’m not happy about it, I lose sleep about it, and everyone knows I’m in quite upset about it, so this is a moment where I can talk to you without being filtered through a few dishonest journalists.

The simple problem is there’s a number of ways in which stock trades can fail to settle, or there can be an expansion in the number of shares, or share-like things. There are failed short sales, which are the famous naked shorting, which I don’t even think is the bulk of the problem. I think it’s a lot less than half the problem. This failed long sales, opened positions at the DDTC, desk trades at the brokers, share entitlements, which are very slippery. I call these phantom shares, not to be outrageous but I’m saying on the one hand, there’s a number of shares that the company issued and which have been borrowed once and sold again, and so they have a clear chain of title, and then there’s the total number of shares that the world thinks they own, and there’s a difference between the two in some companies, and whatever that difference is, you can call it phantom shares.

I understand that they represent three problems. One, it’s blown our system of corporate governance. The current issue of Bloomberg magazine has a fantastic article about this with a whole bunch of people from the back-office of Wall Street, the securities transfer people, and they’re talking about how votes are cast twice. One guy says “Votes are cast twice on almost every matter of substance. It definitely can and does, in my experience, affect the outcome of corporate elections.” Well, you can’t hold corporate elections if people in the back office are just throwing out extra proxies to make votes tally.

I thought of doing some kind of -- I’m sure many people on the phone had, or will join on this call, had problems getting their proxies. We mailed them out within the window. Everyone should have gotten them. I heard some complaints. I’d like to know how many people -- of course, we can’t find out how many people really got proxies.

I thought actually by putting up some sort of non-binding public referendum to my shareholders on the subject of should I be fighting this crusade or not. I figured that I would probably get 65% of my shareholders saying they’re against it, and I would get the other 210% would be for it.

Second thing it does is these phantom shares distort a market price. The orthodox response is that can’t happen if [inaudible] are dumped into the system, the market can’t move very far before some ocean money comes in to support it. The orthodox answer is right if you’re talking about IBM. But if you’re talking about a fledgling firm paddling into the market, and somebody dumps a bunch of phantom shares into its market, of course it can be cap-sized. Everyone on the phone has taken economics. Stock at an illiquid will act like a commodity. Phantom shares will shift the supply curve to the right. That will collapse the equilibrium price, which the guy selling fake Rolexes on the street in front of you can explain.

It doesn’t happen with IBM, but it can happen with start-up companies, software firms, drug companies, especially if their business is about which it’s easy to confuse the public, which it’s easy to do if you have a stable of captive reporters whom you can dictate what you want written.

Speaking of which, I want to correct something. Over and over you see reporters saying “Byrne blames his stock price on naked shorting”. That’s a lie. You’ll notice that none of the guys who attribute that to me, guys and gals, ever have a quote supporting it. I have never even lamented Overstock’s price. I’ve never come out and said we’re undervalued. That’s a lie. I’ve never discussed Overstock’s valuation within the context of naked shorting, or said that naked shorting has driven our stock down.

The journalists that write those articles and repeat it with parrot-like -- you know, they repeat it -- never have a quote to support it, and Holman Jenkins, in a recent Wall Street Journal article, actually went so far as to fabricate a quote. I mean, he repeated all the standard party lines, and he actually fabricated a quote that said if I’m crazy, why am I running a public company, or something like that. That quote was completed fabricated. It doesn’t resemble, it’s not a paraphrase of anything I have ever said, and he very artfully constructed the sentence so that when I went back at him, I’m sure he’ll say “Oh, that was a hypothetical quote. It wasn’t a fabrication, it was a hypothetical quote.” But he was lying when he said that. I mean, this has really gotten strange. We’ve got columnists in the Wall Street Journal fabricating quotes out of thin air.

Third, the real problem is I think that unsettled tradings may be collectively comprising the system. Why do I think that? Well, for one thing, the SEC says on its own website when they explain why they grandfathered in January ’05 all failed deliveries, they say “The grandfathering provisions of regulation show were adopted because the commission was concerned about creating volatility where there were large pre-existing open positions.” Now, those would be the same large pre-existing open positions that people say I’m nuts to believe in.

So the SEC acknowledges that it can’t clean up the problem for fear of the volatility if they forced these unsettled trades to close. I think that’s my point. Beyond the SEC, there’s been a bunch of economists like Robert Shapiro, Lesley Bonney, who have studied this and have written interesting papers.

The deep problem is the DTTC, we have a clearing system. The DTTC is an opaque corporation owned by the banks that use it in proportion to their use, i.e., therefore Goldman and a few others, the SEC by all accounts sends over junior regulators who say “how does the SEC do its job? Okay. Are you doing it” Not even clear if the SEC gets that much cooperation. It’s an SRO, except on the days when it isn’t. When the DTTC gets subpoenaed by state regulators, it just rips them up. It clears 30 times the world’s gross world product, so it’s owned by the people who profit if it turns a blind eye to issues like do they deliver things when they sell them?

So in a nutshell, I say, does that sound kosher? Does that sound like the right way to organize affairs? I didn’t want to fight this fight. It was my dharma to fight this fight. I’m telling you there’s a crack in the financial system. It’s filling up with phantom shares until they so warp the market, the SEC is saying it has to grandfather the unsettled trades for fear of creating volatility with their large pre-existing open position.

So what do you think they’re talking about? What does it mean when the regulator says there’s large amounts of unsettled trades in the system, and if we force them to settle, it would create volatility extreme enough that we, the SEC, are afraid to make people do it. Does that say anything, then, to anybody here?

I’m sure Roddy Boyd of the New York Post and others will have a field day with what I said already -- “oh my gawd, he said kosher! He said Dharma! What a nut!” That life for them must be doing caps over and over again. Of course, the New York Post is for folks who move in there once when they read People.

But in closing, these guys can laugh all they want. I think that first, I don’t think I seem like a guy who cares a whole lot about what other people think of me. The financial community can continue with a deluge mentality, but I think that you have to ask yourself, what’s the world going to look like if I turn out to be right? Now, the punch line is I am right, and I think that folks are going to start finding that out practically any moment now, that I’m right about a lot of this.

So, I’ve given ten minutes, we should have given time for the operators to process the long queue that I was told existed. We’ll go to the company.

I told you we ran into a ditch. It’s going to take us the first two quarters, at least, to get out of the ditch, and I think the third to get back with momentum. We grew 9% and lost $16 million. In the second quarter, we’re going to lose about $16 million. When I say that, by the way, I mean, if it were $20 million, if I thought we were going to lose $20 million, I’d say we’re going to lose somewhat more than $16 million. I think I’m going to lose $14 million to $18 million in the second quarter, and I think we’re going to grow -- growth may pick up a little bit. In the third quarter, we’re going to start growing somewhat faster again, and losses will come down. I think in the fourth quarter we start making good money and then we’ll back and we have our momentum back up.

I’m going to go through a slide deck, as always. I feel like I’ve driven around with a hood off to try to let the public see what goes on here. I have some detailed slides about some of the inner workings that I’ll be exposing in a moment, but first, David, why don’t you walk through what you want to walk through?

David Chidester

Okay. I’ll walk through some of the financial results of the first quarter, and note that all comparisons that I make will be against our results from the first quarter of 2005, unless otherwise stated.

Total revenue was $180 million, an increase of 9%. Gross margins were 14%, down 90 basis points. Gross profit dollars were basically flat at around $25 million. Sales and marketing costs were down to 7.3% of sales. That’s 280 basis points improvement from last year. This is a reflection of a 22% decrease in overall marketing expense year over year. However, technology and G&A expenses combined were 15% of sales in the quarter compared with 7% last year, and with the significant investment we made in technology and G&A during 2005 to support future growth, we began 2006 with a much larger expense structure. This, combined with slowing growth, will result in significant increase to technology and G&A as a percent of sales for the first 9 months of 2006.

A big portion of the increased expense structure is depreciation. Total depreciation was approximately $7 million this quarter, and should be around $30 million for the year. In addition, almost $1 million of the tech and G&A expense in the quarter is for stock-based compensation, as we’ll now record stock option expense in accordance with FAS 123R. Although we have never been proponents of EBITDA, I will point out that between depreciation and options expense, approximately $35 million of our expense structure in 2006 will be non-cash.

Total operating expenses grew 42% to $40 million, which translated into a $15 million operating loss, or 8.3% of sales. Our net loss was $15.9 million, 8.8% of revenue, and $0.82 per share, compared to a 22% loss per share last year.

We ended the quarter with cash and marketable securities of $52 million, and an additional $30 million of availability on our lines of credit, for a total of $82 million of cash plus availability.

Cash at the end of the quarter included $49 million of foreign currency bonds that were meant to mature this fall. However, subsequent to the end of the quarter, we sold the foreign bonds, turned them back into cash. In addition, we planned further reductions in inventory over the next three to four months, which will also enhance our liquidity.

Lastly, operating cash flows during the quarter were an outflow of $73 million and free cash flows were an outflow of $80 million. For the trailing 12 months, cash flows from operations were an outflow of $44 million, and free cash flow was an outflow of $82 million.

You’ll find additional quarterly metrics on our investor relations website. With that, I will turn the call back to Patrick.

Patrick Byrne

Thank you, David. We are trying something new; both a new vendor for the webcast and I am doing this offsite, so I see the slides at the same time you the viewer see them. In the past, if you wondered why we had all of these complaints about comments on the slides not being synchronized with what you were seeing it was because from inside the system, you saw it at one speed and the world saw it at a lag. So I am at home so I should see these at the same pace you do.

Operator, could you go to the next slide, please? Kevin Moon, Dave Chidester, can you advance it?

David Chidester

Patrick, go ahead, and you advance it yourself.

Patrick Byrne

I can't advance it.

David Chidester

Yes.

Patrick Byrne

Sorry, the controls didn't come up for me to advance it.

Well, while they are getting that advanced, I will explain what the first slide is going to show you. It is going to show you a chart of our order management score, and this is one of the things that actually got Jason out of his semi-retirement, to… Well, if you have trouble, I do believe people at home can download this and watch it later, perhaps, or follow along.

We have a way of scoring what we think of as aggravation points to the customer, and it is a very big matrix that says if this order has been late for this kind of reason, for this many days, how many points it is per day and everything. It is easy to rack up a lot of points when you are doing 20,000 or 30,000 orders a day, or 50,000 or 60,000 or 70,000 as we were in fourth quarter.

Of course, our ERP system came in August/September, is when everything started to unspool. So when we started calculating this score, we were well over about 1.5 million points. We have it down to 15,000 points now. What that means is we have it 99% cleaned up. 15,000 points may even sound like a lot, but a small number of orders can generate hundreds of points, so we really do have things like 99.8% satisfaction. In fact, I think they are tighter than they ever were before. David, have you -- can you not advance the slide from your end?

David Chidester

I think everybody advances the slides with the little arrows at the bottom on their own. Do you not have that at the bottom of your screen?

Patrick Byrne

I don't.

David Chidester

Okay, so people can advance it as we go.

Patrick Byrne

Okay, I have some gibberish HTML has come up rather than any buttons for me.

David Chidester

Okay.

Patrick Byrne

Okay, so you advance it as you go. I was just talking about slide 4, ERP Implementation, Order Flow Management Score.

Next on slide 5, marketing efficiency. We spent 22% less on marketing at 90% growth. Nothing stellar, but it is interesting. We just had a vendor who does a lot of good statistical analysis do a huge multi-barrier regression going back several years on all of this different spending and how it is done and how it has affected growth.

What she came up with was, and we had been operating on some -- really two steps of very basic rules, that each one of them can be explained in five minutes, and I probably have explained them at times. Just with these very simple rules, it determines how much we spend, how we whack it between online and offline, and then online, how we chop it up within the online spend. We didn't have a good rule for how we handle offline. But still, she came back with this multi-barrier regression that turned out that her numbers came out surprisingly close to ours.

Page 6, Net Promoter Score. I am not a big business fad guy, but there is a book that has really impressed me by Fred Reichheld, the same guy who did the Loyalty Effect 10 years ago, which had quite a -- if you read about CRM and the value of team, the lifetime value of customers and stuff, a lot of that came out of the book, The Loyalty Effect, or at least he ties it together. He's come out with a new book called The Ultimate Question that seems quite plausible, and it has count your net promoters. That is, a promoter is if you ask people, would you recommend me to a friend, or a company to a friend, ranking it 1-10 and you take the people who are 9’s and 10’s and subtract those who give 1’s through 6’s and you get your net promoters. It explains a lot of the variation in results.

Again on page 6, we took off ordinate. I can say, that according to his book, the average American corporation is under 10%, he says 8% or something somewhere, and that the superstars are in the high 30’s to 80’s. We have, surprisingly to me, even in our dip, we were in that band. We've taken out, we don't want to give a precise number, but you do see the dip starting last August and what happened.

I mean, that breaks my heart because we spend so much time trying to service millions of people in years past, but this last year, we had that problem. Customers have stuck with us and it has bounced back to be almost as high as it ever was. Now that we are measuring and managing through this number, we expect it to get significantly better. I expect it to keep on improving, and I think there is actually a one to two month lag effect. This, if I’m to really compare it with the numbers in his book, this is in the upper half of the total superstar score. So we seem to have a lot of happy, loyal customers.

Page 7, we have gotten really focused on the customer satisfaction, we've restructured this CS organization. We are focusing on agent training, quality. We have a contract that has been announced with Right Now, we have decided to go with. Until now, we have been operating customer service on a package that literally Sam Peterson wrote back in the summer of 2000 in the space of a couple of weeks. That has been our customer service. This is our last sort of -- sometimes I think of the last year as a big props/jet conversion, like the airplanes in the 60’s that went from prop to jet conversions. We have gone through a prop to jet conversion, and Sam's homegrown system, while fine, was inadequate for the size and the kind of features we need here.

So when that goes live, which should be in June, right now customer service is costing over 2.5% of sales. I think it is possible to get that to 1%. I have heard that other companies, I have heard that Amazon is less than that. But I think it is possible to -- it actually ran 2.8% in the first quarter. That was the right thing to do, we were a little bit higher than in the past, but we had to smother our customers with love. I think it should be possible to get it down at least below 1. That is why I think there is -- for example, there would be 150 basis points or more to pick up.

Page 8. Operations. Upgrade warehouse management system, that’s nearly complete. We are building a mezzanine in the center of our warehouse, a high-density pick space, 3-storey 25,000 square foot mezzanine, so 75,000 square feet that we think we’re going to be able to condense about 80% or 90% of our pick into. Right now, last year it cost us about $3.50 plus in total variable cost per package. I think it might be possible -- well, it should be possible, I think ultimately, to get that to $2.50. That is, an average package is about $60, so that is 1.7% of margin increase. That is on core only, so that translates into an 0.8% increase in overall margin.

So if you wonder where I've gotten these numbers in the past as we've grown from 9% margin to 14%, 15% and I keep saying, well, I think there is another 200 or 300 basis points, it is in these areas. Stephen Tryon is doing a fantastic job managing the logistics chain and has built a very strong team. Our return to processing has also been a big part of this year.

Going forward, page 9, analytics. Propeller has been integrated site-wide. It’s only making recommendations in some part of the site. There’s a new version expected in Q2. We’ve had to build something that ties together a lot of different propellers into our new propeller. You’re seeing it show up more and more on our site.

Site design -- we’ve adopted a system that’s so powerful I don’t even want to tell the name of this company, and I know that they’re overwhelmed with demand at this point anyway, but a company that helps you in your site design, and we had a 3% lift last month. I think there is quite a few -- just by changing one thing, and we’re basically doing one big test per month, and optimizing things as we go. I would like to think that for several months, at least, there’s sort of 3% lifts or more in each one of these changes.

CRM as applies to e-mail, we have started personalizing e-mails. It’s giving us somewhere between satisfactory and remarkable lift. It’s not remarkable, but it’s very solid lifts, very measurable. Unfortunately, even with all our new fancy equipment, we could only do 100,000 at first. It just uses so much power to bake these e-mails. We’re up to about 500,000 and with some changes we made, we’ll be able to do 2 million personalized e-mails per day, starting in probably September or October. That’s a good chunk of the 8.5 million e-mails that we do have.

Page 10, and last, common questions. Marketing efficiency, talked about gross margins, gross profit. Going back, marketing efficiency, again we did cut way back on marketing. We have found from some independent analysis that we do seem to have the right basic cuts of things, but this analysis suggests to me ways we can tweak things a little bit as well.

Our gross margin I think is going to be stable for the second quarter, as we keep making these changes, but I gave you the reasons why I think there’s 200 or 300 basis points. I ultimately think this is a 17% or 18% gross margin business, and I think we can get there in the near future. In the fourth quarter, certainly a number around 17%.

You’ll see us grow more slowly again in the second quarter. 10% growth is fine as we fix all this stuff.

Liquidity -- I know folks are talking about liquidity. I don’t see -- I’m always more comfortable doing barrel rolls close to the ground than my passengers. I don’t see us as having liquidity prices. Although a few years ago, as I told people, there was a day when we ran things down to $3 million in cash as we built inventory, and everybody -- we have a good precise control on it.

But at any case, we’re not doing that now. Just yesterday, this Lehman thaw, this foreign currency thaw that Lehman did a great job for us with, that was a basket of Asian currencies, we traded out of yesterday for $49.5 million. We could’ve waited until September and November and gotten $50 million, but you at the time value money, $49.5 million is good now.

That’s actually going to imply that it will pick up. If we hit mark, with this strange bond that the accounting said is even though we knew we were getting at least $50 at the end of the period, you marked it down as you went, and as the dollar depreciated, which was a surprise, we’ve been marking the value of this down a few million dollars, about $2.5 million, so there will be a bit of a pick-up there.

So we have the $50 million, we have to pay off some debt with it, but I think we’ll be fine for this year, as far as cash goes.

Okay, David, that’s the end of mine. I’m sorry I could not advance my slides. I just got a bunch of HTML come up on my screen where the button should have been. So let’s go to questions.

Question-and-Answer Session

Operator

Thank you very much. (Operator Instructions) Our first question comes from the line of Aaron Kessler of Piper Jaffray. Please proceed.

Aaron Kessler - Piper Jaffray

A couple of quick questions. One, on the customer acquisition costs, given that the marketing cost decreased pretty significantly -- it’s about 7% of revenue -- why didn’t we see customer acquisition costs come down a little more? It looks like it was pretty flat year over year.

What’s your view now, given that you looked some of the brand marketing from last year. Can we still see a lift in Q1 as revenue’s only grew 9%? Thank you.

Patrick Byrne

David, do you want to talk about customer acquisition costs? I don’t have that in front of me.

David Chidester

Yes, I think like Aaron said, it was flat over Q1 of last year, below $20, which it wasn’t below $20 all of last year, besides the first quarter. I think it’s a reflection of partially as we get bigger, the new customer growth is slowing, so you’ve got less new customers over the spin that we have, so the mix is moving a little bit more towards repeat business than just new customer business, and that makes sense now that growth is slowing.

Patrick Byrne

We think that the value of a customer is significantly above $20 for us, so we’re fine with that. I’m sorry, what was the second part?

Aaron Kessler - Piper Jaffray

The second question is in terms of the brand marketing. What is your sense now for the lift you got from brand marketing over the last couple of years here? How much of that translated into revenue growth in the first quarter?

Patrick Byrne

Well, we know we have cut way back in the brand marketing. That’s where a lot of the cuts have been. It’s trickling along at a much reduced rate than last year, as you may have noticed. But just measured in terms of name recognition and all that stuff, I think we’ve built a very good brand. As I think we reported, we went to 29% unprompted name recognition over two years.

So I’m in favor of it, but I think we’ve reached the point where the marketing guys say you go through these different phases, awareness, acceptance, all this stuff. We clearly have created awareness. We don’t need to keep drilling people in the forehead with the same ad over and over, as much as they like to be. I think we can go at the other end of the extreme, as somebody like Oreo, who just every year takes two weeks and drills the public for two weeks, and everybody remembers Oreo cookies, and that’s all they need. We’re not there yet, but you will see us stay back.

Plus the brand advertising, we’ve accomplished what we set out to accomplish, and I think that we can keep it there with a significantly reduced spend.

Aaron Kessler - Piper Jaffray

Thank you.

Operator

Thank you. Ladies and gentlemen, your next question comes from the line of Doug Anmuth of Lehman Brothers. Please proceed.

Doug Anmuth - Lehman Brothers

Thank you. A couple of questions. My first one is regarding -- it sounds like you have a lot of things going on with a need to get finished, rather, by the June/July time period, like the warehouse build-out, the new customer service application. I just wanted to get a sense of what your confidence level is that those things actually get done sort of by the time we really get into the back half of the year.

Secondly, you gave a pretty rough outlook in terms of your claim that you could do break-even or better EBITDA and operating cash flow for the year. Do those numbers still hold? Thank you.

Patrick Byrne

Stand by, I’m just making notes. On getting the customer service and mezzanine thing done, first of all, customer service. My confidence level is good on that. It is actually supposed to be finished in early June, so I’m confident we can finish in June. It’s an ASP model that we went with, which greatly simplifies. I wish we had done this before. It greatly simplifies the whole implementation, and they’ve sent a first-rate team. I think that we will be one of their larger commercial clients. They’re giving us a lot of attention, and it’s so far, they’ve been working on it a month, or six weeks, and my impression is a very professional team, and we have the resources.

We’re just getting much more organized, so when we do things like this, it isn’t grabbing a couple of extra programmers and working at nights and weekends. A lot of our increase is in technology spend, where we just had a lot more technologists and developers and such.

So it’s getting to look more like a real company when we do things like this. But if there’s any, I would say it’s right now, just because it’s the nature of any software implementation customer service app. You know, you can always imagine that running over. So I can imagine that running over.

The mezzanine, no. The mezzanine is bolting things together. It’s funny that you ask that. We actually had a truck full of important parts coming in through L.A. through southern Utah, ran into a cow and tipped over. That actually has literally stopped the project for two weeks. But short of any more cows on the interstate, I don’t see how that gets delayed. That’s just bolting things together.

As far as break-even on an EBITDA basis, definitely. It would be hard for us to break even on a GAAP basis, but with $35 million of depreciation and amortization, having that back into the -- I would imagine yes, we should break even or better.

David, do you want to follow up on that?

David Chidester

I think when you look at break-even cash flow, I still think we can get there. If you look at the last 12 months, the trailing 12 months operating cash flow is a negative $44 million. $31 million of that is just inventory. You know, we’re just a lot deeper in inventory than we were last year. We believe we can run the business with much less inventory. So if we can bring that inventory number down in particular, we do believe we can do break-even cash flow for the year.

Patrick Byrne

Let me comment on that, because we were, our electronic data warehouse on the one hand didn’t give us everything that we started off expecting from it, but what it did do was it saved our bacon and the whole ERP problem, because as the ERP system sort of spewed everywhere, we caught it all with an electronic data warehouse, and it really saved us there.

But we still have, I think, three or four months left, and we’ve built an electronic data warehouse team, [Labida] is from Terra Data and from other good companies, big retailers whose name you would know with a lot of good experience, who are -- it’s all bolted together and it’s been working, but I would say that what we used to have in our homegrown systems was at 10, and our new systems, they’re probably a 6 to an 8 in terms of our business intelligence, but I think they’re on their way to a 15 or to a 20. Meanwhile, our old systems that were on a 10 were failing.

One of the first things that they have done that’s been very powerful is they let us do much more sophisticated inventory analysis, and we just really think we should be able to squeeze a lot out of our inventory.

I think we showed -- what did we show, $81 million ending the quarter? David?

David Chidester

Yes, of inventory, yes.

Patrick Byrne

Now that includes $7 million of diamonds, and I just had an offer last week to liquidate the diamonds. If I ever want to get out of them, I can liquidate them at a profit. So we sort of think as our inventory separately from the diamonds, so $74 million. That $74 million is already down in the mid 60’, and I would imagine that it ends the quarter in the low 60’s. I really think that, from the analysis we’re getting now, it may be possible to squeeze -- I don’t want to overstate it, but I actually think that the analysis suggests we can squeeze several tens of million more out of the inventory with the business intelligence we now have.

So in that sense, the system is actually…anyway, go back to Dave’s… yes, we had a $43 million negative operating cash flow in the last 12 months. That’s because we’ve gone from $50 to $81 in the inventory, so $31 million of that is just inventory creep.

Doug Anmuth - Lehman Brothers

Can I also just ask you, you mentioned that there was something in terms of site redesign that gave you 3% lift last month. Can you give us anymore detail or insight into that?

Patrick Byrne

Sure, in fact, I’m so excited about it I hate to -- I don’t even want to give this particular company props, because I don’t want my competitors knowing about it, but there is a company we’re working with that it has some very cool technology. They actually were the only people doing this, but somebody else just started, a competitor. Very sophisticated, it’s called Genetic Algorithms. I guess I’ve probably just given it away, but genetic algorithms is a -- the company is call Optimos.

They come in and take a page, and there’s a lot of set-up time, but they take a page, say our product page, and you say here’s five or six different ways I could have the button place, here’s five or six different ways I could have this placed, that placed, and it senses.

So they take a subset of your traffic. Now, all those different billions of permutations, you have 20 different variables with five or six ways each, it could be said there’s billions of permutations, so they run a test on a subset of your traffic for a week. Then they do an aggression, find the best factors, they sort of mate them all together -- hence the genetic algorithm -- they mate them all together and create a thousand offspring, and then they test that for a week, and then at the end of the week, you take the eight most fit offspring and you mate them together, and you get another thousand. You do that a few times, so it evolves into the right combination. We think doing that one page at a time -- there’s basically six or seven major pages in our website -- the product page, the homepage, department, categories, sub-cats, store, department, and we’re going to sort of do that each month, page by page.

I guess it’s not really a secret, because I do know that other big-names in the industry have their own teams, so I haven’t really -- it’s not like I’m giving Amazon a secret. In fact, I know that there’s a guy from Amazon that’s a big scientist, their former chief scientist, I believe, is the guy who set up the competitor to Optimos. So this is a leading edge area. The gains in it seem pretty substantial, but there’s a lot of setup time for each one of these tests.

I hope that wasn’t more than you wanted to know, but…

Doug Anmuth - Lehman Brothers

No, very helpful. Thank you.

Operator

Thank you very much, sir. (Operator Instructions). Our next question comes from the line of Scott Devitt of Stifel Nicolaus. Please proceed.

Scott Devitt - Stifel Nicolaus

Thanks. Two questions. The first on accounts payable in the quarter. The pay-down was $64 million, was up, I think 170% year over year. I’m wondering what the explanation is there, if it is related to any changes in terms either with suppliers on the direct inventory or in terms of paying partners more quickly on the commission side, and then I have a follow-up.

Patrick Byrne

David, why don’t you start off and then I’ll chime in.

David Chidester

A lot of that is just a reflection of the slowing growth, because we’re still paying partners the same we’ve always paid them. We are a little bit ahead on paying partners just because we had some billing issues with the new ERP system, so we sort of stayed ahead of the game to make sure we’re taking care of our partners, and we’ve actually paid a few extra days than we normally would have had, so that accounts for a few million of it.

In general, as growth had slowed, and the mix of our business moved more towards the core business and the partner business last quarter, either to accounts payable go down more than it has historically.

Patrick Byrne

Because of the ERP problems, we reached a place where it was hard for us to pay precisely. We’ve been fanatics on paying our -- David’s instructions since the first days have been we always pay our vendors. I want to have the best reputation with them, because that’s the nature of the closeout business, and vendors were partners.

In fact, we went from, about a year-and-a-half ago, we went to paying electronically, so it saved five to ten days because they didn’t have to wait for the mail. We started paying them with these little electronic checks, which they love.

When we started having these problems last fall, I said to David let’s pay the high side of whatever we think we owe them at the end of every two weeks. We actually got a lot of cash in front of some vendors, and then in the first quarters, we’ve been able to sort of tune in and recreate exactly, and reconcile sort of more to the penny. It was just a good sort of karma to always pay. We weren’t able to count in the payments. We were able to count at our end, but not for them to reconcile exactly the returns that we had to deduct, so we always just paid them extra.

So that has started to come back to us now, actually. Actually, now, we can pay them precisely to the penny, but in the first quarter, we were still ahead a little bit.

We have had some funny things happen. Some of the bankers, and in this case one of the major prime brokerages had actually gone to some of our partners and tried to get them to stop, tried to raise doubts about us, and they seem to be trying to ferment a run on the bank kind of situation. One of the three top guys, they are out there going to our partners and trying to -- because we’ve actually had one major partner call and say you can’t believe the call I just got from one of the banks trying to get me to shut you off.

Scott Devitt - Stifel Nicolaus

Just a follow-up on the direct gross margin. It was down 300 basis points, and I think, Patrick, in the letter you noted warehouse costs as being one explanation. I’m wondering, because the inventory level was high coming out of 4Q, what component of that was pricing just to drain inventory levels as well.

Patrick Byrne

There’s definitely a piece of that in the first quarter, and there will be a piece of that in the first part of the second quarter, although we’ve come out of it now, but we did mark things down in order to flush things through. So that hurt our margins a bit.

Scott Devitt - Stifel Nicolaus

Thank you.

Operator

Thank you very much sir. (Operator Instructions) Our next question comes from the line of Frank Gristina of Avondale Partners. Please proceed.

Frank Gristina of Avondale Partners

Thank you. Back on the direct business, was free shipping involved at all in the volatility? To review, the direct business seems to have a lot of volatility, even year over year, in the gross margins. I guess pricing, warehouse costs, is shipping an aspect there?

Building on that, you don’t seem to have the volatility in the fulfillment business, so why would you just open the doors to fulfillment partners and really try to make that business larger in the mix and drive your margins higher?

Patrick Byrne

Okay, I am going to take that. David, do you want to go first?

David Chidester

I'll just comment quickly, Patrick, and then you can finish. Part of the reason the direct business has more volatility is that we have our B2B business, we have some core BMV (books, music and video) that has lower margins. So as those businesses move -- and sometimes the B2B business is more moving inventory out, maybe slower moving, lower margin -- so depending on how the BMV core business and B2B businesses move, that can have an effect on the overall margins. But the direct does have some more moving parts than the partner business does.

Patrick Byrne

Although I was going to say, how I was going to answer, Frank, was that the pricing is the biggest element in the volatility. The shipping is an element as well, although we are cutting back on the free shipping, we are not using that as extensively. The smallest element of the volatility is the warehouse handling costs. Now I do think that we are going to be able to take a nice sliver out when we get this new mezzanine finished, but it is not like suddenly the warehouse started running badly. It was much more pricing and changes in our shipping policies and how often we give dollar shipping and things like that.

As far as partners, we've built to 700 partners. We're about to have a way to increase that several fold, if we want.

Frank Gristina - Avondale Partners

Is there any reason why you wouldn't want to? You could still own the customer, but just not have to deal with the warehousing and shipping issues.

Patrick Byrne

No, there is no reason we wouldn't want to. There were reasons in the past, and that was we were less confident of our customer satisfaction from partners than we were of ourselves. We now have ways that we are able to measure that, as of a week ago. We can, in the middle of May if we want, we can increase our total number of partners about fivefold.

I don't think we are going to increase it fivefold, we don't want to be Yahoo! Shops, but we are, I think, on the verge of filling in. We don't want to just compete with the current partners, but we think we can fill in. We are not going to increase it fivefold, but we will have our pick of increasing it in areas where we have not been selling products yet; we've had a very sparse selection. We will be able to increase it with partner products.

But I am not sure I would see an overall, other than in those sparse areas will get filled out. What we are also learning is not to have too many products. We wonder now if we may have too many SKUs. We certainly have discovered that the 20-80 rule is… Anyway, we are not trying to overwhelm the customer with choice anymore. We are trying to refine it to the best choices.

Jason is on the line. Jason, as you know, was named President earlier this week. For the oldtimers here, I think everybody regretted when Jason retired a few years ago, but I know Jason has some strong thoughts on this. So Jason, why don't you come on the line and answer. First of all, tell the world why you left and why you are back, if you want to, and how you feel about this. I know you have a lot of thoughts on this question. Jason?

Jason Lindsey

Hello. Can you hear me?

Patrick Byrne

Yes.

Jason Lindsey

Well to answer the question first, why not just open it up to everybody? I think the answer is, as Patrick said, we don't want to be Yahoo! Shops. There is a tradeoff between selection and clutter, and that is a fine line which we spent a lot of time lately looking at, and we are going to try and hit that line as close as we can. But I think you will see more partners come online soon, especially in areas where our selection is limited.

As far as why I left, I left for the reason I said I left. I had health problems in the family. My wife got --

Patrick Byrne

You don't have to go into all of that if you don't want.

Jason Lindsey

But I had real health problems in the family, and spent a lot of time in the hospital with the family, but everybody is doing great and I am happy to report that everybody is fine and has been for a while, so I am anxious to be back and it is good to be back.

Patrick Byrne

Jason has actually been behind the scenes here, the whole time, in the sense of one day a week coming in and helping, co-presiding with me. He has always really been my co-CEO, really, since we started the Company and we've just made it official. He's come back basically full time for this year so far, and will be full time going forward.

Anything else, Frank?

Frank Gristina - Avondale Partners

No, thanks very much.

Patrick Byrne

And I mean, we love the partner program. We are starting to love it more, even. Okay, operator. Next question. I think we have time for one more question.

Operator

Our final question comes from Derek Brown of Pacific Growth.

Derek Brown - Pacific Growth

How much cash do you think you will need to reignite growth for the fourth quarter, and when do you need to have that cash to build inventory and make sure the store is filled and the shelves are stocked?

Patrick Byrne

My answer is, I don't think we need more cash. I think we can run our inventory much better than we did before, so in the fourth quarter what we have now is probably the right amount to enter this fourth quarter with. We have built it up too much in the past, is what we've learned. Jason, what is your?

Jason Lindsey

Sure. Hi, Derek. I think we have plenty of cash as well. One thing we learned, obviously, since we have way too much inventory now is we went through the Christmas season last year with way too much inventory. So if you look back and calculate any kind of ratio of, how much inventory do they have going into the season and how much do they need? The season being the Christmas season, I think you will see, like Patrick said, the inventory we have on hand now is probably plenty, so we don't really need a bunch of additional excess cash to build our inventory levels.

I do say that I think you will see over the next few months we will continue to buy more inventory and sell more inventory, so our mix will change but I don't think we need a bunch of cash to build our inventory levels.

Patrick Byrne

Would you agree Jason that it is going to decline and then swell up again in September, October?

Jason Lindsey

Yes, absolutely.

Derek Brown - Pacific Growth

Thank you.

Patrick Byrne

I guess we do have time, if there is -- is there anyone else, operator?

Operator

Actually, that was the last question sir. We are going to turn it back over to you for final comments.

Patrick Byrne

Well as I said, Jason -- why don't you make some final comments.

Jason Lindsey

My thoughts from 30,000 feet are we stumbled, and we know we stumbled and don't let anything we say seem that we're making excuses or that we don't realize that we stumbled. However, in the long run it might be a good thing for the business. We grew 100% year after year after year, and when we had a debacle, we had replacing all of our systems this year; obviously we shrunk a lot. When you shrink that dramatically that quickly, your financial results look terrible.

But it has given us the time to take a deep breath and harden all of our systems. Historically when we were growing that fast in the past, we were trying so many things and launching so many new businesses. The thing I am encouraged about right now is that everything we are focusing on and everything you hear us talking about are all hardening and building the infrastructure for our core, internal shopping business.

You haven't heard us say anything about any other business other than Overstock merchandise to our customers. That business is getting a lot of attention. It is getting more attention now than it has ever gotten, and as bad as the systems got, I think Patrick mentioned before when he was talking about our aggravation points, I think the core shopping business as far as somebody orders a product and they get it on time -- I am not sure our business has ever been better.

So from the customer side, it is better than ever. From the investor side, the financial side, now we are spending an equal amount of time making sure all of the internal systems to make us manage our business and have it be as efficient as it can, just for the core shopping side, it is getting that attention now.

So I think investors should be pleased and in the next six months to a year you will see a big difference in our financial performance because of it.

Patrick Byrne

Thank you, Jason. We went a long way on a thimble full of systems and I blew it. I should have realized six months earlier than I did that when those systems reached their limit, they were going to reach it, they were going to work until the day they didn't, and then they really didn't work.

So to me, this is all a function of bad decisions I made in the first half of '05, both in that they were belated and then I made a bunch of them and we tried to through a bunch of stuff together and we stumbled. It is taking us the first quarter to the second quarter and we'll assume the third quarter to pick ourselves up and dust ourselves off and get going.

To Jason's point, one of the things we get so excited about is we realize now -- the Japanese teach this way of thinking in manufacturing that you drain the reservoir until some rocks emerge, and then you go and you blast the rocks, and then you drain the reservoir some more, until some rocks emerge. Then you blast those rocks.

We had drained the reservoir all we could on our old systems in the sense that we couldn't have gotten better or more refined looks at inventory or refined looks at marketing, and we certainly couldn't have done analytics that underlie personalization and so forth. We couldn't have gotten any better than we were.

There are these transition costs, we've moved to a bunch of big honking professional powerful systems and off this sort of stuff that was all duct taped together, but there are transitional costs. Now that we are on it, we can drain the reservoir a lot lower than we could have under the old systems in terms of fixing problems and such.

Jason pointed out, we didn't even mention the other tabs. I will mention that travel beat budget for the quarter. Auctions was just a little bit behind budget. Last year we lost nearly $5 million in auctions and the goal this year is to break even and I think we should come at least within $1 million of that goal in auctions.

And we don't really have any great new businesses planned. We are just refining what we have. Okay. Well thank you for sticking with us, the long-term owners, and I am sure like me you welcome having Jason back to provide adult supervision. I look forward to talking to you in three months and again, expect pretty much the same thing. Expect pretty much the same thing for one more quarter and then things will start getting better in the third. Thank you.

Operator

Thank you very much sir. Thank you ladies and gentlemen for your participation in today's conference call. This concludes your presentation and you may now disconnect. Have a good day.

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