Many of our best shorts come when we can identify large gaps between how bullish investors and management are portraying a situation and what we think the objective facts support. In the case of Overstock.com, we believe the gap between perception and reality is as wide as we have ever seen. As a reminder, we shorted Eros International PLC (NYSE: EROS) ("Eros PLC") and Geron (NASDAQ: GERN) because we believed the reality was starkly different from investor perception and how management portrayed their businesses and prospects. Both management teams made outlandish statements and were briefly able to kite their stocks as investors bought in. However, the reality was nowhere near as positive, and both companies saw their share prices plummet to close to $1.* We see a similar future for Overstock.com (NASDAQ: OSTK) (“Overstock”) as investors come to understand that the reality of the company’s businesses is actually quite negative. We wouldn’t be surprised if the shares trade close to $1 in the near future.
People Think Overstock’s Retail Division Is Turning Around, But It Is Suffering Its Worst Revenue Declines In History
On its last earnings call, Overstock’s management team profusely congratulated themselves on the amazing turnaround achieved in the retail division. CEO Patrick Bryne made statements such as, “Our retail business has snapped back quicker than anticipated, delivering positive adjusted EBITDA,” and “We're very bullish about our retail business.” They also pointed to positive SEO trends (slide 31) as signs that the retail business is firing on all cylinders.
We believe the truth is very different. We do not believe the retail division has turned around. In fact, our research indicates that there’s substantial evidence to suggest that the retail business is imploding and may be beyond repair.
Overstock management clearly wants investors to focus on the improved profitability of the retail division. As we’ll show later, we believe this is solely due to a discretionary change in how management is accounting for expenses and that on a like-for-like basis, the retail business continues to generate losses and to burn cash.
We think that the most alarming part of the retail business is that it’s seeing accelerating revenue declines.
In fact, the current retail revenue declines are the worst in Overstock’s history as a public company. Below is a chart of revenue growth and declines over the last 12 years. Even during the worst parts of the Great Recession in 2009, the revenue declines in retail never got this severe. We have not seen any signs of a revenue turnaround in the business and believe revenue declines may be getting worse.
While management states that the retail business is stabilizing and improving, we believe the revenue trends are clear evidence that the retail division has not turned around and that its performance is deteriorating rapidly.
We believe A Recent Accounting Change Allowed Overstock To Report Profits In The Retail Business
Overstock’s management team loves making a big deal about the improved profitability of the retail division. On the past earnings call, Dave Nielsen, President of Overstock Retail, stated, “Many expected this turnaround to take years to return to profitability.”
In the 2Q 2019 earnings release, Overstock has a table that shows the retail business has generated what appears to be a modest profit.
We believe this “improvement” in profitability is due to an accounting change that management began employing the last two quarters. This change is disclosed in the fine print section of the earnings release. In it, Overstock states, “Beginning in the first quarter of 2019, we began allocating corporate support costs (administrative functions such as finance, human resources, and legal) to our operating segments based on their estimated usage and based on how we manage our business.”
Without the accounting change, the retail business would have been loss-making on a non-adjusted basis (i.e. how Overstock has reported its retail EBITDA historically), as can be seen in the 2Q 2019 presentation (slide 22). If Overstock had not changed its accounting practice, we assess that the retail business would have lost $2 million during 2Q 2019 and lost $10 million year to date through June. This may not be apparent to investors who rely mainly on earnings releases, and these investors may get the wrong impression by focusing on Overstock's reported profitability numbers.
Contrary to management’s multiple statements that the retail business turned profitable during the quarter, we believe that an accounting change was the source of profits in the retail business and that the retail business remains under significant pressure.
Overstock Is Burning Cash And Has Less Than One Year Of Cash Based On Its Trailing Cash Burn Rate
Management also likes to portray that the company is on its way to solid financial footing, making statements such as, “We'd like to be operating at a place in the next year or so where retail profits are more than able to fund the Medici Ventures' operating outlays,” on the last earnings call. We see no signs of this, and it appears to us that the company is in a dire financial situation.
Due to the losses at the overall company, Overstock is still burning cash. Last year, Overstock had negative free cash flow of $167.6 million. Through June, Overstock has burned another $76.4 million in free cash flow. Now, cash reserves appear to be running low. Trailing twelve month free cash flow is negative $160.7 million versus current cash levels of $121.3 million. Based on trailing twelve month cash burn, Overstock has less than one year of cash remaining.
To offset its high cash burn, Overstock has utilized its At The Market (“ATM”) facility with JonesTrading. Through June 30, 2019, Overstock raised $52.1 million net dollars by issuing shares at an average price of $17.84, and from August to December 2018, Overstock sold stock worth $97.0 million in gross proceeds. We think Overstock management has demonstrated with its actions that the current share price is a great price to sell shares.
This issuance has caused Overstock’s share count to rise from 28.8 million on March 8, 2018 to 35.3 million as of August 2, 2019. In other words, as the Retail division has suffered revenue year-over-year declines of 9%, 18% and 23%, Overstock has been diluting investors by 23% by selling shares and only disclosing the sales in its SEC filings.
Unfortunately for Overstock, the company has fully utilized its $150 million ATM facility with JonesTrading during the second quarter, which was revealed in its 10Q:
“In August 2018, we entered into a sales agreement with JonesTrading Institutional Services LLC ("JonesTrading"), under which we conducted "at the market" public offerings of up to $150 million of our common stock. As of June 30, 2019, we had sold 5,843,147 shares of our common stock pursuant to the sales agreement and have received $146.7 million in proceeds, net of $3.3 million of offering costs, including commissions paid to JonesTrading.”
We think this is alarming. Overstock has $121 million of cash after raising $150 million through the ATM since August. If the company had not tapped the ATM one last time, the company would have completely run out of cash. Overstock continues to burn cash, and we believe Overstock currently has limited avenues to raise cash and may be under future pressure.
We believe Overstock’s Retail Business May Be Irreparably Harmed Based On Customer And Employee Online Reviews
During the 2Q 2019 conference call, Overstock management made multiple statements about how the retail business is resonating with customers, and said the retail business has built a “more personalized relationship with the customers” and that they’re “generating smart value for the customer.”
We disagree. The reality appears to be that the retail business is disliked by both customers and by its own employees.
On Trustpilot.com, Overstock.com has an average 1 Star Rating and is ranked as “Bad.” We encourage any investor who believes the retail business is headed for better times to read the reviews.
A recent 1-star review states, “Overstock is scams and lies!! This company doesn’t even deserve one star that (blank) scam me and don’t care about making it right.”
Another 1-star review from July 29, 2019 warns others, “I wish I had read all the bad reviews before I ordered from Overstock.” And another 1-star review from July 28, 2019 states, “This is the worst place i have ever bought furniture from. They sent me damaged merchandise and have still not refunded all of my money.”
We know that many review sites skew towards customers who are dissatisfied with their shopping experience, so we compared the distribution of reviews Overstock received with those received by its competitors. To do so, we measured the percent of positive reviews to the percent of negative reviews for each company, with a lower number being worse. For instance a score of 0.5 would mean there is one positive review for every two negative reviews. As can be seen in the chart below, Overstock scored by far the worst of all of the companies we measured:
Even many employees at Overstock seem to be dissatisfied. Many of the recent glassdoor reviews are shocking, with warnings such as this one where a former Buyer in the retail business states, “Don’t get sold the dream,” and “Whoever is in charge of running the retail side clearly should be fired. They don't know what they're doing and then after all the damage is done, they fire people to save a few bucks after holding a meeting with the CEO where he's telling people not to be worried. So many mixed messages and suspicious activity going on.”
In a May 2019 review from a current senior software engineer, the employee calls Overstock a “sinking ship” and writes, “The company is an absolute disaster with no real plan. The Retail side of the business is always in talks to be sold so the company can focus on the worthless crypto side.”
We also measured overall reviews on glassdoor for Overstock. The company was tied for worst and – amazingly – came in well behind routinely derided companies such as Wal-Mart:
While Overstock management wants investors to believe the retail business has turned around and that its prospects are good, the reality appears to be quite different. We believe the retail business is seeing alarming revenue declines. We believe its profitability is due to a recent accounting change. Finally, based on reviews from customers and employees, we believe the Overstock retail business may be too damaged to be repaired.
tZERO Appears To Be A Failing App
Overstock management makes similarly effusive statements about the tZERO and Medici Ventures businesses. During the 2Q 2019 conference call, Overstock claimed that tZERO is a “killer app,” and that Medici Ventures is a “wonderful symphony” and specifically mentioned its progress in Blockchain-based land governance, voting and motion picture financing. We believe the evidence suggests that tZERO is struggling to gain traction in the cryptocurrency community, and we struggle to see the value of Medici Ventures’ offerings.
In terms of tZERO, we haven’t found evidence to suggest that it’s a “killer app.” We looked for the tZERO app in both the Apple and Google Play stores, and found that adoption of tZERO has been dreadfully limited.
As for the tZERO token itself, the price is down nearly 60% from its issuance price of $10 per token and just traded $12,000 in total volumes in a single day.
While management claims tZERO is a success and investor perception is that tZERO holds a lot of promise, we believe the reality is quite different and are less positive on tZERO’s future prospects. We doubt that non-accredited investors will rush to buy a token that lacks liquidity and has shown no ability to return to its issue price.
Outside investors appear to share our view since Overstock has had trouble getting outside investors to invest significantly in tZERO. We do not believe that GSR’s $5 million investment is a real comp because GSR walked away from its initial investment of up to $270 million. From our perspective, the $5 million looks like a termination fee that Overstock has positioned as an “investment” into tZERO, or a way for both parties to save face. In either case, we believe such a substantially reduced level of investment is not indicative of significant value for tZERO.
We Believe Medici Ventures’ Product Offerings Lack A Value Proposition
As for Medici Ventures’ other product offering as part of its “keiretsu,” we struggle to see the value proposition. During the 2Q 2019 conference call, management specifically mentioned their progress in Blockchain-based land governance, voting and motion picture financing. Motion pictures are readily funded, and there’s a lot of competition from traditional studio companies and newer entrants like Netflix and Amazon Studios that appear to have limitless budgets.
In terms of land right governance and voting, these are largely well functioning governmental services. We haven’t read widespread reports about people having their land titles stolen from them, and don’t see a need for people to go the Blockchain. Furthermore, evidence of voter fraud is very limited. These are also governmental services that aren’t high ticket items. We struggle to see how Medici Ventures will make a lot of money from local municipalities for mobile voting apps, and from African countries for land governance.
tZERO Dividend Is Unlikely To Result In A Short Squeeze
Lastly, some investors in Overstock believe the Overstock’s announced Digital Voting Series A-1 Preferred Stock (“digital preferred stock”) dividend will result in a short squeeze and spike the share price. We think that’s highly unlikely based on clear precedent from clearing houses.
For guidance, investors can look to the Options Clearing Corporation (“OCC”) Rules and By-Laws, which are publicly released. The OCC is the world's largest equity derivatives clearing organization, and these clearing houses govern all the financial transactions that we do through SEC registered clearing agencies. We believe the OCC’s policies are inline with those of the major banks in principle. It’s our understanding that the rules across these organizations are similar because the major banks have large options market making operations which work in close cooperation with their securities lending operations in order to hedge the options positions of the market makers. If the policies were not in harmony, it would create significant difficulties for the banks across their various divisions. These clearing houses and the major banks will be the ones that determine how Overstock’s digital preferred stock will be settled given that the digital preferred stock is not able to be acquired and does not have an ascertainable market price (or at least does not have a sufficiently efficient and liquid market for the institutions to ascertain a useful market price).
We believe the relevant section starts with Section 19, Shortage of Underlying Securities (page 90). Based on our reading, we believe that when a company is unable to dividend or deliver a security pursuant to its obligations under an option contract, and the OCC determines that there is a shortage of the underlying security (like Overstock’s digital preferred stock) and there is no reasonable likelihood that sufficient supply will become available in the foreseeable future (also like Overstock’s digital preferred stock), then the OCC will allow for the delivery of the underlying security to be cash settled. While each clearing house and the major banks will have their own specific policies, we believe that they largely agree in principle and that the major institutions handling Overstock’s digital preferred stock will come to the same outcome (cash settlement) even if it is not ultimately through the same mechanism.
We believe Overstock’s digital preferred stock checks all the boxes under which the clearing houses and the major banks will settle the delivery of digital preferred stock in cash instead of delivering the underlying security.
For people who are interested in reading the relevant section, please see Section 19(a)(4)(c):
That actually makes a lot of sense to us. Most Overstock investors don’t hold a brokerage account with Dinosaur Financial Group, LLC, which they would need to have in order to trade the digital preferred stock, and there will be many holders who don’t set one up in time. Dinosaur Financial Group is a broker-dealer that is a subscriber to PRO Securities ATS, an SEC registered alternative trading system operated by PRO Securities, a tZERO subsidiary. In other words, Overstock investors need to create a brokerage account with an entity ultimately owned by Overstock in order to trade the digital preferred stock.
In addition, large holders of Overstock like Allianz Asset Management GmbH, Blackrock and Vanguard likely don’t want to create a Dinosaur Financial brokerage account in order to receive the digital preferred stock, and in fact the bylaws of their mutual funds and other investment vehicles may not allow them to hold such a security at all, which is common. Finally, there is some evidence to suggest that Overstock will not allow for the digital preferred stock to trade for six months after they are issued in order to comply with applicable securities laws (although it is not clear that the securities laws actually mandate such a trading restriction). Therefore, it is not likely that there will be sufficient supply of the digital preferred stock to provide for the physical settlement of all option contracts.
In addition to the clear precedent that exists for a cash settlement of the proposed digital dividend, we believe there are significant financial motivations on the part of the investment banks, asset managers and exchanges to facilitate an orderly cash settlement. For both the investment banks and asset managers, hard to borrow securities like Overstock are major revenue generators. If companies are able to easily cause a short squeeze by declaring Blockchain-based dividends, short sellers will quickly abandon the practice of shorting hard to borrow stocks and, in the process, they will destroy this revenue stream for the investment banks and asset managers. Likewise, the national exchanges like the NASDAQ create significant value through their network effects and economies of scale. As a result, they will not want to see volumes leave for crypto based alternatives like OSTKO. By making moving to crypto unattractive to listed companies with high short interests by making sure it doesn’t cause a squeeze, the national exchanges create one fewer reason for listed companies to leave them.
Based on the above, our reading of the Rules and By-Laws of major clearing houses leads us to believe that Overstock’s dividend preferred stock is likely to be cash settled by the major banks who have similar policies as the OCC. This would negate any possibility of a short squeeze, which we believe many Overstock investors assume will happen.
We believe Overstock Offers A Compelling Short Opportunity
We believe the most compelling short opportunities exist when perception wildly differs from reality. Eros PLC and Geron were two of our most recent successes shorting this theme. We believe Overstock is next.
The perception and management commentary is that the retail business has turned a corner and turned profitable. We think the reality is that the retail business is suffering its worst revenue declines in its history and remains unprofitable.
Overstock management also wants investors to believe that tZERO is a raging success and that Medici Ventures’ many product offerings will take off and produce out-sized profits. In reality, it appears to us that tZERO and its token are failing in the marketplace. The tZERO app appears to have few users on either the iOS or Android platforms, and the tZERO token has fallen in value and trades insignificant volumes. As for Medici Ventures’ other keiretsu offerings, we struggle to see the value proposition in land rights governance, voting and motion picture financing. We don’t really see a need or a valuable problem that Medici Venture addresses.
Lastly, we believe investors clinging to the hope that the digital preferred stock dividend will result in a short squeeze are misguided. The major clearing houses have rules for such a scenario, and we believe they are likely to settle the dividend in cash instead of delivering the underlying security.
As Overstock burns cash and as its businesses contract, we believe Overstock is likely to trade down to $1 per share in the near future, just like Geron and Eros PLC.
Refresher on Eros PLC and Geron.
As a review, in Eros PLC’s case, management promoted the company as the future “Netflix of India” and stated that the business was already profitable through its film production business. We believed reality was the complete opposite and that management was misrepresenting key facts about the business. We believed that competitors were already far ahead of Eros PLC in streaming and that the company used aggressive accounting practices which allowed it to show positive EBITDA while generating negative free cash flow. We wrote about the company when the share price was $12.86 per share. We were proven right, despite being sued by the company, and Eros PLC shares now trade at $1.28 per share.
In the case of Geron, the management claimed that imetelstat was a breakthrough drug that would prove to be superior to Jakafi in myelofibrosis. Geron bulls believed imetelstat would receive accelerated approval through its Fast Track Designation. In contrast, we believed that imetelstat was ineffective and dangerous and that it would fail its clinical studies. Later, Geron management claimed that Janssen Pharmaceuticals’ multiples delays in exercising its option on imetelstat were positive signals. We thought all signs pointed to Janssen declining the option. That’s exactly what happened, and Geron’s share price is now $1.37.
Disclosure: I am/we are short OSTK.