Overstock.com Q3 2006 Earnings Call Transcript

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Overstock.com, Inc. (NASDAQ:OSTK)

Q3 2006 Earnings Call

November 6, 2006 11:00 am ET


David K. Chidester - Vice President, Finance

Dr. Patrick M. Byrne - Chairman of the Board, Chief Executive Officer

Jason C. Lindsey - President, Chief Operating Officer, Director


Nat Schindler - Piper Jaffray

Frank Gristina - Avondale Partners

Scott Devitt - Stifel Nicolaus

Jim Krueger

Good day, ladies and gentlemen, and welcome to the third quarter 2006 Overstock.com Incorporated earnings conference call. My name is Candice and I will be your coordinator for today. At this time, all participants are in a listen-only mode. We will be facilitating our question-and-answer session towards the end of today’s conference.

(Operator Instructions)

As a reminder, ladies and gentlemen, this conference is being recorded.

I would now like to turn the presentation over to your host for today’s conference, Mr. David Chidester, Senior Vice President of Finance. Please proceed, sir.

David K. Chidester

Thank you. Good morning, and welcome to Overstock.com's third quarter 2006 conference call. Participating with me on the call today is Dr. Patrick Byrne, Chairman and CEO of Overstock.com; and Jason Lindsey, President and Chief Operating Officer.

Before I turn to my financial summary, please keep in mind that the following discussion and the responses to your questions reflect management’s views as of today, November 6, 2006 only. As you listen to the call, I encourage you to have our earnings release in front of you, since our financial results, detailed commentary, and the CEO’s letter to shareholders are included and will correspond with 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 27(NYSE:A) of the Securities Act of 1933, and Section 21(NYSE:E) of the Securities and 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.

With that, I will summarize our third quarter financial results. Please note that all comparisons will be against our results from the same quarter last year, unless otherwise noted.

Total revenue was $159 million, a decrease of 6%.

Gross margins were 14.5%, down 120 basis points from last year, but up 10 basis points sequentially. Gross profit dollars declined to $23 million, down 14%. We continue to see considerable pressure on direct gross margins as we reduce and refine our inventory.

Sales and marketing costs were 11.2% of sales, compared to 10.6% last year. Sequentially, marketing costs as a percent of sales increased 360 basis points as we increased both offline and online spend in the third quarter.

Technology and G&A expenses combined were 18% of sales in the quarter, compared with 11% last year. Individually, G&A expense increased 27%. However, to get an apples to apples comparison, excluding stock-based compensation, G&A was up 20% over last year. Technology expense doubled over last year, and just under half of that total expense relates to depreciation, amortization and stock comp.

Total operating expenses increased 30% to $47 million, which equates to 29.5% of sales. This translated into a $24 million operating loss for the quarter, or 15% of sales. Our net loss was $24.5 million, which equates to a loss of $1.19 per share.

Our cash balance at the end of the quarter was $39 million. We had no borrowings on our inventory lines and $32 million of borrowing availability based on our quarter-end inventory balance.

Total inventory and prepaid inventory combined were $72 million, down almost $40 million from the $111 million of inventory in prepaid inventory that we had last year at this time.

Operating cash flows during the quarter were an in-flow of just under $1 million, and free cash flows were an out-flow of $7 million. For the trailing 12 months, cash flows from operations were an out-flow of $19 million, and free cash flows were an out-flow of $47 million.

I will also remind those on the call that updated quarterly financial and customer metrics will be posted to our investor relations website following the conference call.

With that, I will turn the call over to Patrick.

Dr. Patrick M. Byrne

Thank you, David. Jason, are you on the line?

Jason C. Lindsey


Dr. Patrick M. Byrne

I am going to be clicking through slides. Please go to slide 2. There should be no delay. I do not have to read the safe harbor again. I do have an e-mail from a Doug Griffin of Santa Fe, New Mexico, a shareholder, suggesting that I say while I have never really tried to make predictions, I have tried to just sort of tell people what we knew, to say that because my predictions have not been very good recently -- I think that is true, the last year, year-and-a-half -- we will not be providing guidance for the fourth quarter or beyond.

I do not think I have actually ever provided official guidance, but I am not even going to be providing unofficial suggestions. What I will do is share my insights with you regarding the positive and negative factors I see which could impact our future results, and leave it to you to estimate how things will unfold.

That is precisely what we tried to do in the past. Again, the letter you get this morning is pretty much a mildly sanitized letter of what I gave the board not long ago. So again, no predictions but I am just going to try to be straight and call them as I see them and let you know everything I know.

Go to slide 3, please. These are growth rates since we went public. This is, of course, distressing. You see what has happened in the last year. It was staying up at least close to 100, in the 70s, and then it has just been this horrible slide since then. I thought we had arrested it and I thought the third quarter would at least hold its own and maybe edge better, and then be better in the fourth. I will get back to that in a second.

Internally, I can tell you that we have always scaled this business for $1 billion, so that was our thought as to where we had to reach to at least make it a viable business, so this is distressing.

Next slide, slide 4 of 24. This is what has gone on. These are our conversion rates. We are not showing you our absolute conversion rates. David, can I assume that these slides do not have a 20-second lag like they did in previous quarters?

David K. Chidester

Yes, they should not have a lag. Everyone is in control of their own slides on their computer.

Dr. Patrick M. Byrne

Okay, thank you. These are conversion rates since and how they compare with the same weeks last year. You can really see what happened in the third quarter. It was not good this year, in any case. It was not good. I think that if marketing is a three-legged stool and offline marketing and online marketing and everything we do internally to drive conversion, I would have to say that we really do not have that third leg.

As much as we focused in our early years on figuring out the other two legs, that third leg has been our weak point and it now has really come to bite us.

Jason C. Lindsey

The third leg being internal.

Dr. Patrick M. Byrne

Thank you, Jason. Since Jason speaks Patrick, Jason will interpret for the rest of this call.

I have taken over internal marketing. I took over the last week of July there. I think there are clearly dramatic things we could be doing with internal marketing. Internal marketing again is everything related to conversion, customer retention, e-mail, everything, site design, site testing and layout and so forth. I have been on this since the first of August, really.

I will tell you, it has been suggested to me, and I think this is a fair suggestion, that I say that I let the world know, hey, the Jihad is in other people’s hands. It really is. It may be the case, you know, I am making these public appearances when asked. I have always been a bit of a, since the early days when we did not have a real marketing budget, I always did PR because it seemed like the easiest way to get our name out there.

I get asked to do these radio shows now and an occasional appearance. Sometimes the invitation is, the appearances are withdrawn, sometimes they are not. But it is the case that I am not really focused on the Jihad. I am not really crazy about doing interviews about it anymore.

I think that it is a snowball and it has its own momentum. I am focused on this: I sit on the fourth floor. I run internal marketing. We have a team of young folks reporting to me, and we are figuring this out, and there is a lot we have gotten done in the last few months, but there is a long way to go. I think it is going to take us to March, somewhere between March and June to really be crisp at this.

This is our problem in a nutshell. If we were actually expecting to have by the beginning of third quarter some good increases in conversion over last year, and we haven’t. The fact that obviously it was a disastrous third quarter.

I will get into some of those things in more detail. Slide 5, please.

Some of the things we have done is I have just decided, although we finally did get Propeller live, which is our own personalization engine, and some areas of the site that actually got some nice lift, I have just decided it is too expensive and timely, it takes too much time to do this ourselves, and I wanted to get something done by the fourth quarter.

So we went out to three different companies and we have basically outsourced. If you take personalization, you can break it up in a few different areas, and we did a lot of study and found what I think is the best in each of these areas.

There are basically two approaches to personalization. It is called collaborative filtering. It is called a Baysian engine. Choice Stream is really the last man standing in the whole personalization wars. They are a great Massachusetts company. All we are getting live this year is a gift centre. The gift centre is done. It went through QA last week. It is finished. We are using it internally this week. We will probably start turning it on to some of our customers late in the week, and then you will start seeing it in a few little places on the site early next week. Then we will start, just because A, we want to make sure it handles the stress of the traffic, and B, it gets smarter as people use it.

You are going to see us featuring this, and this is a terrific product. It is actually great. I have been using it the last week. We are especially going to market to guys on the prospect of how would you like to do all your Christmas shopping in 20 minutes? You come in, you tell us who you are shopping for, answer a few questions about him or her, your relationship to them, et cetera, and bam, it pops out a whole bunch of gift recommendations, and they are good recommendations and you can see that as you try it on yourself.

That is actually live internally now, and you will start seeing that at the end of the week, early next week.

Collaborative filtering is live. Aggregate Knowledge is a Kleiner Perkins company. I think it is relatively new, that has emerged. I cannot say enough good things about, really about either. Choice Stream was a fantastic team to work with. The integration is very deep with Choice Stream, but they were fantastic people to work with. Aggregate Knowledge is now doing recommendations on our product pages. You see those if you go to our product pages. You will see I think what are good recommendations. They have been up a few weeks. They are providing nice, measurable lift. The nice thing about Aggregate Knowledge is the integration is quite easy.

Content management is a different subject altogether. Kefta is a San Francisco company, and again, we were -- the IT team has had a -- which was on track in all of its projects this year. They were finished in early October, mid-October. I stepped in in early August, or really late August, and said I am throwing three more big logs in the wood chipper that we have to get through this year. I will talk more about content management in the future. Kefta are very smart folks that we have been working with. We will tell you how it works out.

I will also mention that the Choice Stream engines, which powers iTunes recommendations and Yahoo! Gift Center and a bunch of the big media sites, the Choice Stream engine, we are going to in the first quarter roll out, it is going to be doing product recommendations and even doing some e-mail.

Aggregate Knowledge is going to be, by another 10 days from now, doing the product recommendations not just on the product pages but on our other pages in our site, maybe as high as the homepage.

We do have progress on personalization. These things are all either have turned on in the last two weeks or are turning on now. It will take at least a couple of weeks to get tuned in, but we actually see results from them now.

The last thing I will say about this is this was a tremendous load on our IT department, who were just reaching the finish line on their projects for the year, just totally came through and put in three big implementations in the last few months.

There is some good news, that is our brand recognition. We pumped an extra $6 million into marketing in the third quarter. The main reason we did that is what we suspect is there is more of a relationship than we previously knew between the brand recognition that you achieve in the third quarter and what happens later, what happens in the fourth. It seems that you have people all year who never come, but if you tap them enough, then they come in in the Christmas season and start shopping.

We have achieved what our -- three years ago, we set an internal goal that seemed fanciful, of reaching the same brand recognition Amazon has. Well, our last study shows that we have done that, which I find kind of amazing. I will warn you, I am not sure I would accept these numbers -- I am not sure I believe these numbers.

We used the same company and we have used them for three years, asking the exact same questions, so that there is no variation. They did change their methods in this last survey, and they gave us a warning as they changed their methods, so I am not ready to swear on a stack of bibles that these are the right numbers, because they did change their methods.

If you go to slide 7, this shows the difference between Amazon’s brand recognition, unprompted name recognition for Amazon and Overstock. So this would not be affected by a change in those methods. If anything, it would be more precise, because now it -- here they just ask people where do you go online to get a good deal? I think the test is do they name you within the first three. We have now essentially caught Amazon in how often we get named.

That was where a lot of that $6 million investment went. I am quite surprised that we actually caught them like this, and I do believe this chart maybe a little bit more than I believe the last chart, just because the technique was consistent across them.

This is our net promoter score, which I have talked about in the previous couple of conference calls. Again, according to the book, the average American company has an 8% net promoter score. Fred Reichheld identifies a superstars companies in I think the 35% to 70% range, something like that. Our net promoter score is back higher or as high as it was a year ago. You see that valley. This is where we collapsed from our internal problems.

Reichheld says, in this book the Ultimate Question, that this is the ultimate measure of how you are really going to do as a business. So it seems odd to me. I want to talk about this for a minute. If you asked me at the beginning of the year, our plan was just focused on everything to do with fixing the customer experience. Even though it only dropped to 37 in the worst part of last year, that was partially a reflection of that we already had a lot of, we had a reservoir of good will with our customers. We really did worse than that.

Jason has spent this year fixing everything to do with the -- well, I would say Jason has everything to do with the customer making sure they get their products in a timely way, managing the quality of the products, eliminating bad products, eliminating products that generate poor MDS, and Stormy has took over customer care.

Between them, this is to me a phenomenal achievement. This puts us back in the very highest reaches of American companies in terms of our customer satisfaction, and that struck -- I mean, I know that sounds like -- I actually had trouble believing this statistic, that this had come back as much as it had, until last week, the National Federation of Retailers and American Express released their survey, and there they went out and asked, I think it was 8,000 or 18,000 people, just some question like what retailer in America gives you the best customer service. People named L.L. Bean, Nordstrom, Amazon, and Overstock as the top four.

Jason C. Lindsey

Which is on slide 9.

Dr. Patrick M. Byrne

Sorry, thanks. Which to me is phenomenal. I grew up in New England and I think of L.L. Bean, I always thought of as the guys who did it better than anybody did it, and we were not in the top 55 last year, evidently. So I am not quite sure how this happened, other than Jason and Stormy and the rest of the team, you know, the logistics and everything is working. The IT is working. Jason, do you want to -- I am going to go back to slide 8 for a second. Do you want to comment on slide 8 or 9?

Jason C. Lindsey

We spent a lot of time over the last several conference calls talking about how our focus was making sure, and I think we even walked through the scoring system that we developed internally for customer aggravation points, and how we had driven that down from when we first measured it from 4 million or 5 million aggravation points to now, the Overstock aggravation points are a couple thousand.

The only way you do that is just being fanatical literally about every single order and making sure all 17 steps from when they click buy until they have it are executed and they do not ever fall out side of our service windows. The process just flows continually.

Literally, there would be 20 of us in a room looking at all the order flow over the past several days, and we had a way of mechanistically watching it and making sure it all went through. Anytime there was anything that ever hung up, it was not necessarily just about the order, although that was important. What was the matter? Were there any cracks that things could fall into?

We just, over six months, feel like we have plugged basically every one of them. Things break and power gets turned off and we are always making sure things flow through, but as far as just the system working, it works now. When people order something, they generally get it on time just like they were supposed to.

I think we have largely, at least for now, solved the business problem of making sure all these new systems can talk to each other and that our order flow works.

Dr. Patrick M. Byrne

If I had to say something I have learned between now -- and one more comment on slide 8. You see a little dip there. That is actually when we went live with Right Now on the first of August. There was a mild dip, but that is probably the smallest dip of any implementation we have ever done.

What I would have thought at the beginning of the year was that if we could achieve this, if this was our goal, to have this done by the end of the third quarter, which at the beginning of the year seemed impossible, but by the end of the third quarter, to have this back where it had been before our troubles, I would have thought, okay, that meant sales were going to pick up at the same time, that we were going to have a sluggish first or second quarter, but if we got this back and our customer satisfaction was so great, we would have sales pick up. It did not.

I do not know how to explain that. There is a possibility that what it means is you have to get this to pick up and then you have to get through a Christmas season and everybody comes back and rediscovers and tells their friends and stuff, and then it picks up, or maybe not. Maybe there is some factor I am not mentioning. Any comment on that point, Jason?

Jason C. Lindsey


Dr. Patrick M. Byrne

I know you have an opinion, but slide 9, I mentioned. To me, this is having developed a brand recognition that has essentially caught Amazon unprompted, having developed a net promoter score that is a superstar, and a customer care, people name us, volunteer us in terms of having exquisite customer service up there with Amazon, Nordstrom, and L.L. Bean, is something I would not have thought possible. To me, it is what to my mind drives the intrinsic value of the business, and it was the thing we had to solve first.

There is clearly a big problem left we have to solve in marketing, that third leg of the stool, but this was an important focus for us and I am glad to see it worked.

Inventory turns, slide 10. This just shows we were getting the hang of things by 2004. 2005 we I think probably got a little bit -- well, we started going blind in 2005 as our old system, our old business intelligence systems, the homegrown ones, were dying. Instead of keeping them up, we switched to these new systems that were not really ready yet.

They are ready. Jason is running merchandising, doing a fabulous job, and you see us climbing back out of the ditch. I think that there is one more -- as Dave pointed out, we are basically supporting the same level of sales we did last year with 40% less inventory in prepaids. I think there is one more stair step, not as big a stair step, but there is one more stair step in what we should be able to get out of our inventory.

Jason, since you are the guy who is doing it, do you have any comments?

Jason C. Lindsey

No, I agree with everything you just said. We are basically, if you look at Q3 to Q3, we are almost twice as efficient with our inventory now as we were then. I do think there is still room for improvement.

Dr. Patrick M. Byrne

You will see us, at the end of the fourth quarter, I think we should be about where we are going to get. In other words, I am not -- well, there is always room for improvement, but what we have as our internal goal is something that I still think is achievable by the end of the fourth. Then, I do not know if there is a dramatic improvement to come after that.

Slide 11. This is what is really going on with margins. Our partner margins are holding their own and in the last year, they got hurt, same as everything else, by our internal problems. They have come back, and they are holding their own or getting a little bit better, and that slight improvement is coming largely from -- we still handle returns and we do all the customer service, we do the credit cards. Those go into the gross margin and we are getting better at each of those.

The direct margin, what we call the core business, is diving, and it is I think going to -- well, I do not want to make predictions, but Jason, what do you want to say about the core?

Jason C. Lindsey

Well, I think for another quarter, these lines going in opposite directions is probably going to continue as we get rid of the slowest of our moving inventory, and as we do not replace it, hopefully we do not have to go through that again. Then I think you will see in Q1, it begins to come back quickly, and I think it will start to climb and hopefully catch our partner margins. I do not know if it can catch it in 2007, but I hope it could.

Dr. Patrick M. Byrne

I think it should. I am going to put some meat on that, because we think that we can dramatically reduce inventory from here. But to move that amount of inventory, core inventory, we are giving great deals, better than -- well, we are giving great deals and clearing a whole bunch of stuff out, so we will end with extremely fresh inventory and a much smaller amount than you have ever seen us run with as a fraction of sales.

But to do that, to clean out every nook and cranny in the warehouse, is going to require clearance prices on it, so that is why the margins are going to hurt. We are really committed to getting our -- the same enterprise data warehouse that we installed last year that was sort of part of the problem last year, is actually working very well for us now, because what we are able to get now is profitability on a per SKU basis in a way and with a granularity we never did. We can attribute returns costs, returns handling costs, and how many times does a customer service agent have to pick up the phone to handle a problem with this kind of SKU, and so on and so forth.

Now that we get that with such granularity, of course we find, as you always do, that the costs are not spread evenly. The costs are spread in certain SKUs, are concentrated on certain SKUs, so as we -- and we realize we should be getting out of those and probably going to partner products. Jason has been managing that beautifully.

We are not putting new capital into those categories. We are replacing them with partner products. That is going to have effects through the company. To have a warehouse --instead of a warehouse handling 70,000 SKUs, to have it handling the 10,000 SKUs that do the great, 10,000 or 15,000 SKUs that do the bulk of the profit, is going to simplify so many different processes of the company. Our customer service will be cheaper, the warehouse handling will be cheaper. It is just going to be good all around, setting aside that we are not going to have capital tie up in products that we see now are not really the right ones for us to be in.

Slide 12, please. Gross profit less marketing expense contribution margin. This is again what I said last quarter, I believe can be a 10% from the first quarter. I am not retracting that. I am not making anymore statements about the future, but I am not retracting that. Jason, do you have anything to say about this?

Jason C. Lindsey

No, I agree. I think it is obviously made up of two numbers, gross margins, so gross margins need to go up, and marketing expense, and marketing expense needs to go down. I think if they both go in the correct direction, which I anticipate and hope they will in ’07, that 10% is not out of the quarter.

Dr. Patrick M. Byrne

First quarter. Next slide, 13. This is tech expense, and what you see is the dark blue is the expense not including the depreciation, and the light blue is the depreciation, then there is a bit of stock option expense. So what you see is really a hint that it is flattening. It is not completely flat yet. It probably should be flat, but it is flattening. We made our big stair step up and we have to live with that blue bar for next year, and then in the following year, we start seeing a bunch of that flush away. We have $35 million, $40 million in depreciation this year. That will start in not next year but the year after, start drying up on us.

We really have built such capacity in our systems, I really do not think we should be doing very much new cap-ex for a long time in technology.

Slide 14, these are our G&A. You actually see our G&A, again it is the dark blue, is the cash and then there is a bit of depreciation. That is actually flat or coming down.

Slide 15. This is just fixed asset turns, a measure of efficiency. You see, of course, I always like to see how Amazon is doing at something. We actually had, until our -- I mean, Amazon is a scale business. It is going to do $10 billion this year. Even though they are at scale, we actually ran at a higher -- this is just saying we ran lean. We ran very lean until last year, and then last year, we went out and built all this -- I think we started last year, I should check this number, but I think we started -- I mean, you could check it yourself on our balance sheets. I think we started last year with fixed assets of $11 million, on which we were trying to do 800 to $1 billion. That is what just snapped on us. Last year, we realized we had to go out and spend a whole bunch of money. We did it. Unfortunately, just when, of course, if we had known the growth was going to stop, we probably could have eked through on the systems we had. But if we had gotten through on the systems we had, we would probably still be growing.

The next slide is just the same comparison with Amazon when they were about out our size.

Slide 17. Q&A -- we asked people to send in questions. There are some that have come in by e-mail. Some came in I guess last week. Kevin Moon put these together.

Jason, do you have anything else to say on the formal presentation?

Jason C. Lindsey


Dr. Patrick M. Byrne

Okay, we will go to slide 18. Customer service logistics, how are your customer satisfaction scores trending? We covered.

State of warehouse operations and capacity. I think it is -- I cannot believe how well our warehouse is now running. They made some changes this year. Steve Tryon is managing it beautifully. Jason, do you want to add to that?

Jason C. Lindsey

Yes, it is running really well. In fact, we did a couple of tests where we basically gave everybody a long weekend off, made everybody take four days off and let the orders just pile up on us, and then made everybody work. They still got the same amount of hours in a week, but we just stress test the system, including holding all the orders in abeyance here until we could push them through all of our systems all at once. Last year, we pushed through more orders than we ever did in our peak season last year, and last year, even with slightly less orders than we pushed through during this test, our systems were redlining, and in some cases, falling behind.

This time, through that stress test, our systems were purring and I do not think we ever got over 10% CPU usage on our IT systems. As far as the warehouse, Steve Tryon, who runs the warehouse, said at the end of the day they kind of all looked at each other and said “Was that 20,000 lines?” or whatever the number was. It just did not feel like it, and they feel like they can do several times that.

I think our logistics systems with what they can take at the warehouse and the training that they have gone through and the training that they have at different shifts as opposed to just having to throw more temporary labor at it, we have never been in the situation we are currently, logistics.

As far as our IT systems, obviously they did really well through that test. I could not feel better about capacity right now.

Dr. Patrick M. Byrne

I am actually going to throw some numbers on that. Last year, with our new ERP systems, which were not yet dialed in, not tuned in, we maxed at about 6,000 orders processing capacity an hour just on our IT systems. Unfortunately, we had an hour last year in a peak week that we actually had that many orders, or maybe even more.

We spent six months this year dialing it in, getting the right switches set in the database. There are 2,000 switches you have to get just right, and we got them and we now have, in simulation, we have the capacity of 100,000 lines an hour, or 16 times what we did a year ago.

We actually, when we did this, when we simulated Christmas week, by the way Jason described, holding orders for a Friday, Saturday, Sunday, and the Thursday, I think, and then releasing them all at once, we saw we had processed 56,000 orders in an hour. So it has capacity for at least 8 to maybe 15, 16 times the current size.

Our warehouse is contained, simplified. We had an old friend of mine, James Joyce, came in and helped us this year, a logistics specialist. He and Steve Tyron have gotten the warehouse just humming. Our variable costs, we have people picking on average I think much more than twice as much as the average picker was getting picked in an hour last year.

Remember, we are not picking a million identically sized CDs. We are picking all kinds of very different-sized products and those that have a lot of problems in receiving, you have to repackage things, all kinds of stuff. It is a difficult problem, but we actually have -- and it is something you really cannot automate, but just through changes within the warehouse. We used to pick an average of about 35 lines per person, I think, where we have many people picking up over 120 now.

I am sure the average has more than doubled the 35.

Slide 19 out of 24, changes you made to the merchandising strategy. Jason, how much do you want talk about that?

Jason C. Lindsey

We have talked quite a bit about it already. The reality is we have made a lot of changes in the merchandising strategy. Some are personnel changes. Also, we have kind of organized all our reporting differently, so that every buyer, every store that you see on our website has an income statement now, so we can see the profitability by store, which we have never seen before.

Dr. Patrick M. Byrne

Including capital tied up, and we charge on the capital.

Jason C. Lindsey

Yes, and we are allocating more capital to those who have a higher return on capital and taking capital away from those who have a lower return on capital. I think it is going really well. Unfortunately, you see margins continue to tick down. That does not sound like it is going very well, but I think you have to get rid of everything in your warehouse that you do not want and that you do not want to reorder to get to a more efficient state.

Margins have come down. Our core margins, as you saw several slides ago, have come down dramatically. I think we still have another quarter of that. I think next year you will see that trend completely reverse itself.

Dr. Patrick M. Byrne

I think that in fairness, we actually had, when we were much smaller, we had the same basic idea going. I think we probably outgrew our capacity to look at things in that kind of way for a couple of years. Then, when we got the EDW tuned in and we can now look at it by chimney and by capital and by all these other costs getting allocated, it is just very eye opening that the things that you maybe thought were profitable were not so profitable.

Jason C. Lindsey

It feels like the same thing all over again.

Dr. Patrick M. Byrne

Yes, it feels like something -- you mean in the sense of something we did three or four years ago?

Jason C. Lindsey

Yes, I mean as efficient as we got at it three or four years ago, it feels like obviously we are not even close to that efficient again, but it feels like we are solving the same problem we thought we had solved three or four years ago, and then just lost visibility into how to maintain it.

Dr. Patrick M. Byrne

On about 10 times the size. That is fair.

Contribution margin, 10% next year. Obviously, I will just tell you how I get there. I think that I think in terms of gross margins at 17% and marketing at 7%. That can only happen if we move through the last of this inventory that we now identify as not really being as profitable as we thought it was. That is how I think we get there, and that is based on focusing its -- to tell you the truth, this 20% generating 80%, in our case, even more skewed than this [Corato] principal. Jason, do you have any comments to number two?

Jason C. Lindsey

No. I get there by saying we spend 5% or 6% on marketing and having 15% or 16% gross margins, but either one of them would get you there.

Dr. Patrick M. Byrne

Yes. New compensation incentives for buyers. What do you want to say about that?

Jason C. Lindsey

I think the new P&L by buyer is allowing us to see profitability by buyer in a way we never have. I think as we organize our compensation incentives around those, it makes the buyers act like business owners, and I think it is working really well.

Dr. Patrick M. Byrne

I think next year, we are going to be even more, we will have I think a good idea about how to tie their compensation -- their compensation as a group was tied to results before their bonuses at group, with sort of a tip of the hat to individual performance. It could not be anymore granular than the data. It is now to the point where in the new year, we could have a very specific compensation plan tied to every buyer, every tab, basically. Don’t even want to call them buyers because some of them are things other than buyers, but a specific compensation plan tied to each tab.

Slide 20, analytics internal marketing. Conversion rates, progress on initiatives. The problem of the third quarter is that conversion rates were down 25% or so from last year, as that slide showed earlier. To put it differently, if they were not down, I would have expected to have been growing 15% or so by the third quarter, and we didn’t, and it is all the conversion. Everything else, the expenses internally, the buying, everything seems to be managed. We have screwed that down, but the conversion rate, no.

I am not saying it is solved now, but we are buried in the right analytics to solve that. As we built a team, we have built a solid team of a lot of smart people and a small number of very experienced experts in different areas, and these different teams that make up the whole conversion system all report to me directly. I am running that. It has been four or five years, or five years since I have been involved in that part of that business. There is a lot to learn, but things have changed in five years. The technology is better.

On the new website, there have been some design changes. Are you seeing improved on-site conversion rates? Well, as that slide I showed you near the beginning demonstrates, yes, we were. We certainly have, since the middle of the third quarter, we were starting to see some things come in. We are definitely redesigning aspects of our site. There is a lot of testing, AB testing and multi-testing going on these days from different corners of the site. We are finding lifts, a lot of small lifts, but we are really at the beginning of this process.

I think that we really dragged behind the world on this, frankly. You will see some more changes before the end of the year. You will see there are more changes over the next two weeks are going through QA. Fairly significant changes that simplify the check-out process and things like that.

Slide 21, sales and marketing. Marketing plan for Q4, I do not think we will be able to get it down to the 7% this quarter, because there are some -- clearly other than the brand seems to have soared, we did not get our money’s worth for the extra $6 million we put into it in the third quarter, but we didn’t other than we just got the great brand recognition. Another way of saying that is we should be able to cut I think at this point a lot of marketing.

I can be honest. There is just a piece of marketing that I am realizing now we completely missed the boat on. I do not want to reveal what it is for competitive reasons, but there is definitely a big chunk of marketing that we have completely missed the boat on for years.

We are definitely making improvements in it. On Friday, we saw some big results, not in a way that would move the needle overall for the company, but we definitely see results based on what we have done in the last three months, but there is a long way to go. As I said, I think it will take us at least until March, or March to June to even get that reasonably up to speed.

What that means for Q4 though is that we are going to be shrinking our budget down from the 11%, 11.5%, or whatever. We are not going to be able to get it down to 7%, just because there are some things into which we are locked. As I said in my letter, some things are changing in the online spend game rather dramatically at the portals and such, and the opportunities are not there. Actually, a big part of what happened in -- well, some significant part of what happened in Q3 is last year we had some portal deals that died at the beginning of July this year. The portals, the MSNs, Yahoo!s, and AOLs, have changed their strategy and some of the things that were available in the past are just not even available, and they were some of our best campaigns.

Has the campaign begun yet in earnest? Yes, this weekend, we started our Christmas spot on TV.

I said how I intended to keep sales and marketing in 7%. I expect to get it towards there, but we are not going to be able to get all the way there, because there are some contracts that are already fixed that we cannot get out of.

How do you think about new customer growth, repeat customer growth? I would rather answer that at the end of the year. I think we will get a lot of new customers starting in the fourth quarter. Other than that, I do not actually want to quantify this.

How do you view the overall marketing landscape as we move into the Q4 holiday season, graphic ad inventory and so forth? Well, what has happened is a lot of -- I thought that we had reached the high water mark a year, year-and-a-half ago. That is the money that was flooding in from offline advertising had reached its apogee and that prices were not going to keep going up.

Prices, I guess people are still realizing it is more effective than a lot of the offline advertising. For example, as I say, the portals have changed their strategy, search keywords are areas that we did have little niches before of profitability other people have come in and found them and they arbitraged and went away. So that game, I do not think there is a lot to be gotten out of that world anymore.

Jason, do you have any comment on sales and marketing?

Jason C. Lindsey


Dr. Patrick M. Byrne

Slide 22. Revenue growth. Revenue growth through Q4 and 2007. Not going to talk about 2007. Even Q4, all I can say is I am a little surprised -- Jason, why don’t you take this first?

Jason C. Lindsey

I do not know if we have anything to say about that. I mean, we are obviously very disappointed in how revenue growth is trending, but the good thing -- the only good news I see about all that is just that we are diving into it, into an area where we really have been derelict in looking at, and we are just drowning in low-hanging fruit. It is not like there is nothing there to be done. It is quite the opposite. It is there is so much to be done, you are overwhelmed by it, and every single night when the IT, when we roll new code to fix things, it is just how many things can we push through QA in a night? There are just so many things that we think and that we have tested that do move the needle one little tiny blip at a time, but move the needle that is just sorting through them and trying to prioritize and test all these things, and get the biggest winners to the top and get them pushed through.

I do think there is a lot of upside in conversion. That is the real positive I see.

Dr. Patrick M. Byrne

Right. We have really been -- we are discovering how much we missed here. I know that other people focused on this first, and maybe they -- I am sure that was smarter. They focused on this and got this drilled in. Issues of site design, personalization, checkout, and ease of use and such, is what we are focusing on now. There is, like Jason says, I am surprised that there is such low-hanging fruit that has escaped our notice before.

Has slowing growth changed the economics of the business? Yes, it has. As we always, I am not even sure I have talked about this publicly, but we always thought of the $1 billion mark, charging to the $1 billion mark and that was the scale. Being stuck at the $800 million mark presents a problem.

Slide 23, gross profit. You said the direct gross profit margin should be higher than partners once you clear out some of the lower -- yes. When do you expect that gap to narrow? Jason.

Jason C. Lindsey


Dr. Patrick M. Byrne

Q1. To what degree are improved return rates going to help return improved gross margins versus better product mix?

Jason C. Lindsey

I think right now, the reason the product mix affects our margins so much is because there is such a huge difference between the gross margins of each. As you look forward to next year, when we think that the gap will be closed dramatically, the change in mix will not be that big of a deal.

As far as our return rates, I do not think there is a lot left on the table to be gained there. I think there is a lot left to do --

Dr. Patrick M. Byrne

Wait, are you talking about product return rates or customer return rates, when you say you do not think there is much to be gained in return rates?

Jason C. Lindsey

I am talking about customer return rates. Well, what is the difference?

Dr. Patrick M. Byrne

Well, return rates in terms of how often people return something that they order.

Jason C. Lindsey

No, I am talking about products coming back to us, whether the -- I mean, the products coming back to us from customers. I am not sure if that is what this question is asking.

Dr. Patrick M. Byrne

I think I am with you on that. Customer return rates, we are not really disclosing anymore, but they are higher than they were before, but that is partially just when you slow -- when you are growing 100%, it is impossible to have 70% of it be customer return, return customers. Now that we are slowing and now that we have dramatically slowed, yes, the return rate is quite a bit higher, the number is quite a bit higher.

Slide 24, profitability. Kevin had to slip this in on us. Jason, when are we going to become profitable.

Jason C. Lindsey

I do not know the answer to that. I wish I did. I think in our history, we always thought whenever growth slowed, we would become dramatically profitable, and that was because we had such a small expense structure. I think at just about any time during our history, you could have slowed growth and we would have become wildly profitable on our tiny expense structure.

I think last year, we flipped the switch and changed our expense structure dramatically, as you can see in all these slides that have shown how expenses stair-stepped up, and that simultaneously happened with our decrease in growth rates, which put us in the bind we are in.

I think that our growth needed to come back some, needs to come up some, and our expenses need to come down some, and when they do, there is a very valuable business buried here in the middle, with brand recognition of Amazon, it is an extremely high-traffic website, and we have a huge section of our traffic that is extremely profitable and generates a gigantic piece of our gross margin. Unfortunately, attached to it, we have a wildly unprofitable business attached to it that causes the whole thing to lose money.

That is why you see us, or at least you see me talking only about simplifying our business and getting rid of all these things that cause expenses throughout our entire business operations that is unprofitable.

As we get out of that, what you see us doing I think really quickly this year, you will see the business become much more profitable, and exactly when the entire business will turn profitable, I do not have an answer.

Dr. Patrick M. Byrne

The way to get out of those unprofitable businesses in our case is you just stop putting capital into those tabs. We actually have a SKU in the sub-cat level. A lot of this is being done in the sub-category level. Some businesses you can get out of by just, some businesses you just close. In our case, the way to get out of a business is you just stop buying that product.

Jason C. Lindsey

And then remove the expenses associated with all that additional product you do not have anymore.

Dr. Patrick M. Byrne

Right, but you have this period of three to six months where you are just going to be flushing through that product and getting it out of your warehouse. Even simplifying, think how that helps the warehouse, that you do not have all these different types of products, that you can reduce them. We built this warehouse mezzanine I was talking about six or nine months ago, and that has dramatically helped us, but that only works because we are focusing on the very high velocity products that we have found buried underneath all the data.

So I am with you, Jason. As you get out of those, you then realize there is a whole bunch of other expenses associated with that, with holding that inventory and dusting it and lighting it and counting it and advertising it and buying it and so on and so forth, that you really can -- they can leave your system along with the inventory.

That is the last of our slides. Let me see. I do have some mail in.

I believe people e-mailed Kevin these questions over the last few days, but some came in this morning that did not make the slide deck. Have you seen partners defecting or challenging commission rates, e-bay, e-bay express? No, I do not. It is a big world and no, we have not seen any defection or anything like that to e-bay.

Do you have any insight into whether your partners are experiencing gross margin contraction? No. Are you seeing contraction of the direct business? Again, this is from buying, like it’s getting harder to buy. It is just that we are saying hey, here’s $10 million to $20 million of inventory that we do not need and we are going to chop the price and make sure it all moves.

None of these questions -- there are a lot of questions about new customers that are women from Jim Krueger, customers that are women. We do not really want to get into -- maybe at the end of the year, we will go back and give sort of an overview of what has happened with new and repeat and so forth.

Do I still consider Club O to be the best loyalty program on the net? I do not know enough about others, other than Amazon. I think it is well-designed and I think it works very well for us. Our Club O program works beautifully for us. Maybe at the end of the year we will go back and have some charts about repeat revenue and repeat customers.

Arnie Olsen sent me something saying “Please tell the world that you are not fighting a Jihad every day.” I am not fighting a Jihad every day. I do not know what to do if a big radio station says “Hey, why don’t you come on and talk to 50,000 people about it?” It seems like a nice -- it seems like a cheap way to reach 50,000 people and also get them to hear about Overstock. I am not sure I would not do those anymore, but no, I do not like flying all over the country and meeting with lawyers and doing that, and I am really not doing that anymore. I am hear at Overstock and focused on this.

Let’s see. Going to my letter, real quick. Furnace Brook, this was a major victory. Jonathan Johnson, our head of legal affairs, this is sort of an infamous patent troll and this got dropped, kicked out of court. That is a big deal.

Page four, what does the future look like, our NPS score. While I was waiting to come on this morning, I turned on the TV and there they are on Good Morning America talking about us, and they are talking about how if you want to buy high-end apparel, go to Overstock. They did not even mention anyone else. They just talked about go to Overstock, they showed our site.

So something happened in the sense that we have become this household name and we have great associations in terms of customer satisfaction and customer service. We just have to find a way to capitalize on that.

Okay, that was a long talk. I did not mean to use the whole hour. On the other hand, it is probably a pretty efficient use of time because we got through a lot of detail.

Why don’t we go to questions? I will stay on and answer questions. Jason?

Jason C. Lindsey


Question-and-Answer Session

Dr. Patrick M. Byrne

Nat Schindler from Piper.

Nat Schindler - Piper Jaffray

Just a question about the conversion rates. One of the things you had been discussing a lot about is that on the marketing side, but is it possibly more a merchandising issue? From a personal experience, I go and look at the site and look for shoes, and end up finding five or six styles I like, and none of them in my size. Without investing in the inventory, how can you have conversions, or drive conversion rate?

Dr. Patrick M. Byrne

As we are choosing which inventory to invest in, that is one of the issues that is being addressed. If there are shoes that we know we can buy that are going to turn quickly, then we will continue to buy them, but maybe holding on to a pair of shoes that is going to sell just in case, and holding on to it for a year-and-a-half might not be a good business.

In addition, the way to get at that problem, I know how hard our site has been to shop for for apparel, for example, because you had to go in and you find a pair of shoes you like, and you have to drill down and you find out what size they are in, and if they have them in your size.

That is one of the things that changed about three weeks ago. We now have guided navigation in our search, so you can come in and you can search by -- you go into the apparel, you go into shoes, and you say I am a size 7. It shows we have 5,000 shoes or 2,000 types of shoes, then you say size 7, and it comes back and says we have 300 size 7s, 300 models, and then you say I want brown loafers and you can click your way through.

It is called guided navigation. It is not new. It has been around a couple of years, but it really has just gotten mainstream in the last year or two. We have just got it turned on in our site probably mid-September.

So to your specific question, it may be easier to find shoes that you like because of that feature now. We are solving with technology your problem, but also, Jason is going to be solving your problem by if there are enough people like you that want a certain type of shoes, that is going to show up in our numbers and that is where we will be investing capital.

We just will not be investing it anymore doing -- I mean, we were being way too liberal with what we were willing to test and what we were willing to buy without the fundamental analysis that would justify it.

Jason, since it is your world, do you want to --

Jason C. Lindsey

Well, we hear that a lot and the answer to the problem is hopefully guided navigation. We hear over and over, people search and search and search, finally find something that they like, and then it may or may not be in your size, when in fact at the very beginning, you did not have to search and search and search. If you just said show me all your size 9 shoes because I am a size 9, and then you look through them and pick the ones you like, that seems to be a much better shopping experience and a much more efficient use of capital.

The truth is where people go and what people want to find, we do need to have inventory there. It turns out if you look across all our categories, it is not just one category where we make all of our money. The 20%, or less than 20% that does most of our gross margin, believe it or not, really does have a nice smattering across all of our stores.

In places and sub-categories where we do not want to be in, we can back-fill it with partner. It is a much better business model.

Dr. Patrick M. Byrne

It is kind of funny. In a way, you could think of us eliminating 75% of our business, but it is not like we are getting rid of 75% of the tabs across the top. Within each tab, there are -- each tab is a store, within each store, there are departments, categories, sub-categories, and then SKUs. It is more like we are eliminating 75% of the SKUs that we are buying.

Nat, in answer to your question, I just went to apparel, clicked Men’s apparel, and I do not know what size you are, but for example, you click 11 and 12, there are 186 shoes. So it should make it much easier to shop for shoes.

By the way, our search design I hate. If you go to our search page, I hate it. By the way, there has been a tremendous change in the last few years. Four years ago, 21%, 22% of the people who came to our site searched. Now, 38% to 40% on any given day. We call that the Google effect. People have gotten used to search, and searchers convert much higher than non-searchers.

You are going to see us rolling tomorrow night a brand new design for our search results. I think this is very confusing, the one that you see if you go to our site now. The new one rolls tomorrow night and it is much closer to say Back Country Store in how it lays products out.

Nat, if you use our drill-down search, I am hoping you can find.

Nat Schindler - Piper Jaffray

Actually, Patrick, I did do that and I still -- take a look at it, because of the five shoes in the 513 that came back in this last time I went, three of them were not in my size, were not in the 13 or above.

On a related note, you make a lot of comparisons of the business to Amazon, which should be described as kind of a broad retailer. They have, if you want to buy a mixer, for example, they have 45 different colors of that mixer in stock and will ship it to you.

You are more of a Costco. I wonder, the marketing seems to be pushing the message that seems to be more similar to what I would expect for Amazon than for Costco, where if I am looking for a deal, I would come out to look to Overstock just to find something that was a good price. But that is a browsing shopper versus a go to Google search, click on chemical shoes, click and come to the site and not find it.

I am wondering whether or not the marketing message is different from what the business is.

Dr. Patrick M. Byrne

Because we are marketing it as too broad a -- we are marketing it too close to Amazon to say that we are -- well, that is a point. Although -- do I have you right, that you are saying that we are marketing ourselves too much to be like Amazon rather than come here for just the best price on a much narrower range?

Nat Schindler - Piper Jaffray

Yes, like a browse and find great products cheap versus come here and buy whatever it is you are looking for, because that is not -- you are more like Costco. I go to Costco all the time to look for stuff that just happens to be cheap but that I am not particularly shopping for at the time.

Dr. Patrick M. Byrne

That is a good point, and that is how we started off. We used to think of ourselves as a treasure hunt, and we saw, like I say, 80% of people browse, and they had the same conversion rate as searching.

That has changed. In the last few years, we are down to 60% browse. We used to focus on how do you make the -- how do you enhance the treasure hunt atmosphere of the site, so we have these things like just about to sell out, or just sold out, or things like that to reinforce the treasure hunt.

I am not sure that the world -- you know, consumers’ behavior is now indicating that they do not really come and browse, or at least 40% come and search, and they are the ones who really buy.

Well, you make a point. Your point does not fall on deaf ears.

Nat Schindler - Piper Jaffray

All right. Thank you.

Dr. Patrick M. Byrne

Thank you. We have somebody -- could I see that list again, please? Frank Gristina, Avondale.

Frank Gristina - Avondale Partners

Thank you. Good morning. Obviously the direct margins, that is really what we are waiting to turn to prove this model works. I was just curious, maybe Jason, if you could put some parameters around how much inventory you flushed in the quarter, maybe how much is left? If you cannot do that, give us an idea of when you liquidate liquidation inventory, what kind of gross margins are you getting on that stuff that you just want out of the warehouse? If you could put any detail on that, it might help us to figure out where -- I guess what I am trying to get at is how do we know you can get to 17? Have you done some study that tells you if you are not selling the stuff with zero gross margin or negative gross margin, you get 17?

Jason C. Lindsey


Dr. Patrick M. Byrne

Actually, Jason, do you want to answer your question, or is that all -- you want to answer that more fully, don’t you?

Jason C. Lindsey

Well, yes, we did run a test and we know we can get to 17. We know we can get north of 17 when we do not have the things we do not want on the site not there.

Frank Gristina - Avondale Partners

What kind of margins when you are liquidating are you getting, if you are able to give that to us?

Jason C. Lindsey

Unfortunately, they are kind of all over the board. There is $10 million to $20 million worth of stuff in our warehouse now that we do not ever want to have in our warehouse again. We are clearing it out nicely.

Some of the stuff is negative and some of the stuff is fairly profitable. We just do not want to be in that category anymore for a lot of reasons.

Dr. Patrick M. Byrne

We had never priced it correctly, to be honest. We had just -- some of this stuff had 30% margins and had not moved, and it was just a bad pricing decision by somebody.

Frank Gristina - Avondale Partners

Last question, in terms of the conversion, it is possible that it is what the previous caller was mentioning, that the marketing is misaligned, but is it also possible that competition has changed year over year, and that you are doomed to deal with low conversion because you are dealing in competitive spaces? Has it changed that much, or do you really think it is just something on your end that you can fix with some hard work and hopefully not more IT investment?

Dr. Patrick M. Byrne

Go to slide 4, if you would then, please, if you can still pull up the slide deck. If you go to slide 4, this does not look to me like some sea change out there in the world. This is just we were doing something badly. It finally caught up and bit us badly, and we are fixing it. It is going to take another six, seven months to get it good.

Things are changing in the world, but they have not changed that much. They have not changed enough -- you know, when we lose, when we drop 0.6 or 0.7 and you are only converting 2.5, 2.6, 2.8, you are losing a quarter of your business right there.

But there are changes in the world. There are changes in especially what is going on in online marketing. There are a lot of changes, but there is an area that, I do not want to give it away, but there is just an area we have been in kindergarten, and a couple of areas we really did I think figure things out early, but there is an area we are discovering that we are absolutely in kindergarten about. So we have the right, we have some smart people in and we have some experts in to help us develop that area.

Jason C. Lindsey

Just one other thing about product selection, more than half the world still does browse, even though it has shifted dramatically towards search. Product selection somewhere between one product and 10 million products or whatever the infinite number of products is is the perfect amount to have. Not only did we test about removing certain items from our site for a while and seeing what our gross margins could be, we also test the amount of products on our site. We found that we are too far, we have too many products for the browsers, so our selection has continued to go up over the last couple of years. In fact, it has gone up so much that it is to the point of clutter to a lot of our customers.

Yes, when we do not have the right size shoe, you are unhappy, but you are also unhappy if you just have too much junk to sift through. So there is a tradeoff there and we do think by simplifying the business, there are wins to be gained in just minimizing clutter.

Dr. Patrick M. Byrne

In fact, that was actually pointed out to me a year or two ago by some guys, like I think Scott Devitt, who is going to be up next, and maybe you, Frank, and [Crevalin] in New York, that “Hey, you guys have gone from treasure hunt to being too broad”, and Jason has been pounding on this all year. We did some tests, and it is true. When we took off products -- we took some sub-categories and we just stripped out all the products we did not want to have there to see what happened, and actually conversion went up.

We realized that we were, first of all, our search has not been good, and mostly it is our search algorithms is good. It is a company called [Indeca]. The engine is good, but our layout I think has been terrible and it has very awkward to search. Again, a lot of that changes tomorrow night.

But Jason has been saying look at the clutter, and that is what is so distracting. We have tested it, and we are even testing things like how many products do you see per page, 24, 60, 100, whatever, and trying to find the optimal settings.

I think that in the curve Jason just described, we were too far down that curve. When you have thirteen pages of men’s brown loafers or something, then that is a problem. People do not click all the way in and so forth.

There is some optimal point, and I think we were past it. Besides which, it is not like we are not going to have the products. In some areas, we are going to just replace all of our core products with partner products. It turns out there are, in all these little niches, there are partners who are more efficient, probably better buyers in their little niche and more efficient. Some of them it is just because it is a guy working out of his garage or something and he is very, very efficient at one little niche, and in his handling and everything else.

A lot of the stuff that we say we are getting out of, it is not like you are going to see necessarily less of a selection, although we test different areas -- some places you will. We intend to replace a lot of it with partners, and we have no shortage of partners who want to get up on our site.

Frank Gristina - Avondale Partners

Great. Thank you very much.

Dr. Patrick M. Byrne

Thank you, Frank. Operator, I think there is one more question, but you wanted to make an announcement.


(Operator Instructions)

Dr. Patrick M. Byrne

I have a note that Scott Devitt is on the phone.

Scott Devitt - Stifel Nicolaus

Thank you. SKU counts are down year over year, conversion rate is down and inventory is down. Conversely, marketing spending, both the customer acquisition costs and in just general percentage terms, I think it is the highest rate since the first quarter of ’03. I am wondering if there is a correlation between the reduced SKU count, the higher marketing spend, and as you continue to reduce the SKUs, if you think marketing spending in percentage terms is going to remain higher than this 7% number, driven by the less selection on the site?

Dr. Patrick M. Byrne

I am not sure that we really have a significantly reduced SKU count yet, or at least in the third quarter. It is coming down now. Jason, do you --

Jason C. Lindsey

Yes, I do not know what information you are seeing it coming down, but --

Dr. Patrick M. Byrne

It has not really come down yet.

Scott Devitt - Stifel Nicolaus

How about then just focus on the absolute inventory and conversion rates and how that maybe is impacting the marketing spend?

Dr. Patrick M. Byrne

I really do not think -- you know, I could see why you would say if selection is getting worse and worse, they are having to push harder and harder on the marketing throttle, and they are still not able to get conversion up, I think it is really two very different mechanisms. I really do not think -- I am not arguing with you, you could be right -- but I do not see that as what is driving the conversion problem.

The conversion problem is being driven by -- it is not across the board. It is actually up. It is even up in the third quarter in most segments of our business. There are two segments of our traffic that account for a lot of our traffic, which is where it has completely fallen off the cliff. It fell from 2.8 to 1.5, and that is 40% of our traffic.

If it really were being driven by SKU count and stuff, I think you would have seen a more broad-based decline. What we have is two segments that have gone unnoticed, unmanaged, unanalyzed, that we are now just focused on fixing and getting it back.

Jason, what do you --

Jason C. Lindsey

Agreed. I agree.

Dr. Patrick M. Byrne

Do you think that a reduced SKU count has anything to do with this conversion problem?

Jason C. Lindsey

I do not. I think that the first set of SKUs that you are going to see come off of our site and hopefully, it continues, our SKU count does come down, but it is mostly just stuff that is not really selling at all anyway, so it is just removing clutter.

I do not think it is a problem of SKU count.

Dr. Patrick M. Byrne

That is just a hypothesis.

Scott Devitt - Stifel Nicolaus

If I could just follow-up then in terms of the marketing spend, maybe sequentially speaking, what component of the increase was driven by incremental offline spend versus online spend?

Dr. Patrick M. Byrne

On a percentage basis, much higher on the incremental offline. Much higher. I think that we should be spending 7%. Jason would even argue, I think, a couple points less than that. We should not be spending more than 7%. We cannot get down to that this quarter, but we can by the first quarter. We cannot get down to it because we are in contracts that run out this year. We can get part of the way there, but we cannot get all the way there this quarter. After that, I do think 7% should be a constitutional principal, known as a cap.

Jason, any other comment or answer to Scott?

Jason C. Lindsey


Dr. Patrick M. Byrne

Okay. Thank you, Scott. Jim Krueger has come on. Let’s make this the last question. It is 10:20.

Jim Krueger

Patrick, please talk about employee retention and changes in management.

Dr. Patrick M. Byrne

Well, that is a good question. Well, I will mention -- I am not sure if I have mentioned this publicly before, but Tad will be leaving at the end of this year. Tad got married to a lovely woman in New York and they are moving back to New York.

Tad is the last of our -- you know, we have lost some of our depth on our bench at the senior level. Cammy went to Stanford, Holly went back to work in a brokerage.

Jason, my thoughts are colored by emotions here. What do you have to say?

Jason C. Lindsey

Well, I am encouraged with the team that we have. If you look at just the different sections of the business and who is running them, I am quite encouraged. Everything to do with our operations has improved and is as good as it has ever been.

Our whole merchandising team, I think we are undergoing a lot of change there and it is all about simplifying the business, which I think is a really good change.

Another big area where we have failed is our conversion rates and the whole study that has been going on of how do you make your website convert as high as it can? I think Patrick has completely dove into that issue and it sounds like he is just drowning in low-hanging fruit.

If you look at the different sections of the business and who is running them and how they are doing, I think I am quite pleased with where we are at.

Dr. Patrick M. Byrne

Jim, you have hit an interesting point. On the one hand, it is not just us, the names that you know and that I talk about. I would say that the level below that was probably we were too much running around doing too many things ourselves. We have really built up a solid junior executive and management level, I think, in most areas of the business. We are working on that in this internal marketing area, which is the big one. We have some very smart people. We are going to see how they work out. They are generally new.

One of our problems is we have lost some very sharp kids, folks that come in here -- one of our problems is we pay, we have managed to attract people. Good college graduates, very sharp kids, paying well under market rates. The problem is they come here for a year or two and they get offered -- you know, they are working for us for $40,000 or $45,000 and they get offered $180,000 by some Silicon Valley firm.

We have had some loss there, and we have had a lot of loss in the accounting department to a company that is really, a local company that has come in and just hired a bunch of our people and our controllers. I think Jason had built a really, Jason and David Chidester built a really able team there. So we lost a lot of players in the finance department.

I do have to say that in marketing, we have lost, and you know, all these executives can walk out and triple or quadruple their salaries. That has been something we have given some thought to, but I would say countervailing that, we are finding -- Jason, you had some problems with that, too. It is amazing. There are people who are leaving here, who have left here for quadruple the salary, or more. A lot of people, actually, when I think of it.

They are getting replaced in many cases by actually some more experienced people, people from different areas or different industries. I think we are actually doing okay. Jason, do you want to talk about employee retention?

Jason C. Lindsey

We have lost a lot of people over the last year-and-a-half, although I think we have a pretty good team in place to take us to the next level. I do not know what else to say.

Dr. Patrick M. Byrne

I am not talking about the executive team so much as the next level or two. I see some people in very -- I mean, Cammy came in, for example, Cammy and Holly came in and just stunned us. They were so smart and so able. Now they are gone, but we must have a dozen folks like them, in the sense of being very smart, mid-20s, who have come in maybe without a lot of experience but with real eagerness. So that is where we are.

Anything else, Jim?

Jim Krueger

No. Thank you, Patrick.

Dr. Patrick M. Byrne

Thank you. Once again, our mantra all along has been we are just going to try to tell you, you folks know everything we know. We are telling you we are as straight as can be about what is going on. We have had ditches before that we have climbed out of. We do not think the fourth quarter -- the fourth quarter is still going to be part of the ditch, but it is going to be part of the ditch -- but some things are happening. It is not like we can go from the kind of quarter we just had to a resoundingly successful fourth quarter. It is going to have been a lousy year, but I hope the fourth quarter is when we put behind us the mistakes we made in 2005 and are really ready to go on. Jason.

Jason C. Lindsey

I hope we exit 2006 with a more simple, crisp business that you will see throughout our -- and that you will see the results in the financials.

Dr. Patrick M. Byrne

Dave Chidester.

David K. Chidester

No, I agree. I think all the things that Patrick is doing to fix conversion, we did have to step back and fix the entire shopping experience first, and that is what we did this year.

I think we fixed order management. We fixed the customer experience, and now it is time to fix everything related to conversion.

Dr. Patrick M. Byrne

Yes, and that means fixing the site. To tell you the truth, I think it is going to take us until March to June to really get very good, but I know that we can have a lot of stuff. I came in in August, identified a bunch of things to test and change and implement, and we have worked our IT team furiously to get these things built and installed and redesigned and changed, and literally two nights a week now we do code rolls, where you see, if you watch our site, you see these changes. You will see another four rolls last week, four changes, and another few rolls tomorrow night, and you will start seeing.

If you go to our product pages, you should be seeing good recommendations, and those recommendations are going to be extending through the rest of our site in another 10 days. You will see a gift centre up and -- you will see a lot of changes, actually, over the next 10 days. We want to finish by November 17th. But it is not like I can say it will all be fixed by then. We are just going to lock down for the Christmas wave, and then we have another three months at least of solid work in front of us in the first quarter to really getting good.

Well, to all my shareholders, all our shareholders, I say I am eating the same cooking you are. I have not sold a share. I am not going to sell shares. I am just going to ride this out. We have been in ditches before and climbed out of them.

Happy Holidays to all.


Thank you for your participation, ladies and gentlemen. Have a wonderful day.

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