Scott Devitt On Overstock's Challenging Quarter (OSTK)

From Stifel Nicolaus analyst Scott Devitt's note to clients on Overstock.com Inc's (NASDAQ: OSTK) Q1 results:

Summary
We are maintaining our Hold rating. We believe the shares go down not up from current levels in the near-term. We do not believe the company has enough capital to reach self funding status and may raise capital in the second half of 2006. We believe it could be in the form of a private placement given the tight ownership of the shares.

With the slowdown in growth, it seems to us that the fundamentals have continued to worsen, not improve as anticipated. The company now has $30 million in cash, a $50 million credit line, $81 million of inventory, two more quarters of negative cash flow, and an inventory ramp for the holiday season. In our view, Overstock needs to execute flawlessly over the course of 2006 or the shares could be well below current levels.

• Overstock's reported 1Q06 revenue of $180.2 million up 9% year/year and a loss per share of $0.82. We were expecting 1Q revenue of $189.4 and a loss per share of $0.76 in the quarter ($0.70 excluding stock comp).

• Gross margins for the quarter were 14.0%, below our 15.1% expectation. We have modified our view on Overstock's gross margin expansion potential for this year and next, and now believe they will achieve 14.9% in 2006 and 15.6% in 2007.

• We are lowering our 2006 estimate of revenue from $947.3 million to $927.5 million and lowering our EPS (adjusted for FAS 123R) estimate from a loss of $1.99 to a loss of $2.42. We are lowering our 2007 EPS estimate to a loss of $2.09.

Our Thoughts
In 1Q06, Overstock grew its revenue by 9%, of which direct revenue grew by 17% and commission revenue grew by 3%. The company lowered inventory by $11 million mostly due to discounted shipping prices and lower price points. Gross profit on the direct business was 11.3% in the quarter (down 300 bps YOY) and in the partner business gross profit was 16.1% (up 70 bps YOY). The operating loss of $15 million was the largest quarterly loss in the company's history and we expect 2Q to be moderately even higher. The company paid down $64 million in payables in the quarter, up by 170%. We believe the numbers show that the business fundamentals are deteriorating as the growth slows.

The company has $30 million of cash remaining and a $50 million credit line that is collateralized by inventory. It is possible that the company needs more capital by the holiday ramp in 2006. If the company does not require new capital, it will be close. Simply by removing the operating loss over the next two quarters from the current cash position and holding inventory levels constant, one arrives at no cash and a $50 million credit line as the company enters 4Q06.

We do not believe the company can be run on a credit line and thus believe a capital raise will occur sometime in 2006. Our guess is that it would be in the form of a private placement given the ownership structure of the company.

We maintain our Hold rating but believe the shares will trade lower into the possibility of a capital raise. We also believe the company needs to execute on its new initiative of slowing growth to improve profitability or the shares could trade significantly lower than current levels.

Results
Overstock's reported 1Q06 gross bookings were $209.9 million, with revenue of $180.2 million up 9% year/year, and a loss per share of $0.82. We were expecting 1Q revenue of $189.4 and a loss per share of $0.76 in the quarter (or $0.70 excluding stock comp). Net loss was $15.9 million with net loss from operating activities of $72.8 million in the quarter. Overstock reported 1Q gross profit of $25.2 million, an approximate 2% increase over the same period a year ago and a gross margins of 14%, down from 14.9% in 1Q05. Customer acquisition costs (or CPA) reached $19.40 for the quarter. Aggregate unique customers in the quarter were 9.642 million, up 53% year/year from 6.284 million.

Unique customers were 1.321 million, down 3% year/year, with new customers of 638,000 in the quarter. B2C customer orders in the quarter were 1.856 million with average order size of $104, up 13% year/year from $91. Travel bookings were $10.6 million and auction gross merchandise sales were $8.1 million in the quarter.

Overstock.com had cash and marketable securities of $51.8 million (excluding the credit line) and working capital of $66.8 million on March 31, 2006. The company ended the quarter with $81 million in inventory, and generated negative FCF of $80 million ($72.8 million loss in cash flow from operations and $6.8 million in capex).

For 1Q06, operating expenses grew 42% to $40.1 million; sales and marketing expense was down 22%; technology costs grew 232%; and G&A costs were up 82%. Operating losses were $15 million, up from $4.4 million last year.

Initiatives and Outlook
Management noted that the emphasis in 2006 will be on an improved customer experience, integrating a new CRM application, and improving agent training. Further, the company will look to upgrading the warehouse management system, optimizing the returns processing and implementing a warehouse leadership training program. The company is going to be focusing on site design, personalized e-mails and project propeller, of which a new version is expected in 2Q.

We are lowering our 2006 estimate of revenue from $947.3 million to $927.5 million and lowering our EPS (adjusted for FAS 123R) estimate from a loss of $1.99 to a loss of $2.42. We are lowering our 2007 EPS estimate to a loss of $2.09.