Overstock.com Over A Barrel?

| About: Overstock.com, Inc. (OSTK)
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Overstock.com (NASDAQ:OSTK) put a temporary hold on its stock's long swoon when it reported 1Q '12 in April, showing improved expense control and a concomitant return to profitability. The company stated that it had saved around $3.5mn in personnel costs as it slimmed down the organization. The online retailer also benefited from lower legal expenses. On a y/y basis, Overstock successfully cut approximately $5mn/quarter from its expense structure.

On the first quarter conference call, OSTK's CEO, Patrick Byrne, proclaimed that the company had achieved the "Holy Grail" by producing profits in the 1Q as "everything else becomes fine-tuning in Management." Byrne also confidently noted "…I do think that we've turned the corner on revenue growth and you can see it climbing back into the black immediately."

The market took Byrne's message to heart and has since propelled Overstock higher by forty percent. Investors have clearly embraced the profitable growth story that Overstock has reclaimed. The two Street analysts who follow the stock appear to be looking for 8.3 percent growth this quarter, five percent growth for the year, and $0.24 in earnings in 2012 (projected to double in 2013), according to Yahoo Finance. Overstock is thus trading at a lofty 29x this year's earnings expectations (which I believe are grossly optimistic),14.2 fwd eps estimate, (also optimistic) and 44x LTM FCF (155mn mkt. cap./3.5mn FCF). The cynically-minded might correlate Wall Street's enthusiasm for Overstock with the company's $200mn shelf registration, but let's set that aside.

Is all the optimism justified? We have enough examples of Overstock over-promising in the past that it's a question worth considering. As recently as this time last year, the CEO asserted that the company would grow at a rate "at least" as fast as the industry average in 2011. Well, the industry grew at around 14 percent last year, and Overstock shrunk. I think it goes without saying that we should accord Mr. Byrne's prognostications a fairly wide margin of error. Quarterly revenue has declined on a y/y basis for three consecutive quarters (despite comparing with the Google penalty last quarter) and has not grown at a rate over two percent in the last five quarters. Overstock is losing market share because it's a small player in a business that's all about scale. It's fighting the battle against behemoths like Amazon (NASDAQ:AMZN), Ebay (NASDAQ:EBAY), and Walmart.com (NYSE:WMT) by shrinking, and while the strategy may win it a few reprieves, it clearly won't buy it much time.

Why am I so reluctant to believe that Overstock can achieve growth and profitability in a sustainable fashion?

During the 1Q conference call Overstock's CEO, Patrick Byrne, was asked about the potential for further cost saving cuts. He answered by saying that the company had made all of their cuts and could even see some hiring going forward, especially in IT development. So for now we should assume that OSTK is able to shave roughly $5mn from its operating expenses quarterly on a y/y basis. It might be a bit more or less depending on the quarter.

This leaves us with an operating structure that entails roughly $160mn in annual expense (vs. $180mn in 2011). This excludes depreciation, interest expense, and other income/expense which add approximately $20mn in expenses. If we break this down on a quarterly basis, Overstock has to generate approximately $45mn in gross profit to break even under its new cost structure.

If we impose the "new and improved" operating structure on OSTK's top line results last year, we see that the firm would have lost money, but would have been close to break even. OSTK generated gross profit of $179mn in 2011 which would have almost covered its $180mn in costs that we project for this year. The firm would have generated profits in the 1Q and 4Q while losing money in Qs 2 & 3.

Overstock has shrunk its business in order to survive in a world that offers the company little prospect of growth. The firm has faced the reality that it is ceding market share in a rapid fashion to larger enterprises, that are generating positive returns on invested capital in the current environment. These larger firms are investing huge sums of money to gain this share and it puts OSTK in an increasingly tenuous predicament. They must either give away merchandise at lower margins to encourage growth (not much room for that given the balance sheet constraints and operating cost structure), or protect margins and see the top line stagnate or begin to shrink. Thus far they have chosen the latter.

Management is groping for a solution that would enable Overstock to generate growth while protecting its P&L. They tried to game Google's search algorithms and we all know how the penalties affected the company as a result. Last fall they began to shift marketing strategies again (see Alexa search traffic data) to focus on non-search-related customer acquisition in hopes of driving growth.

On the 1Q conference call Byrne claimed that the new marketing strategies were working - "I think we've discovered some profitable new marketing opportunities." Yet later, a seemingly contradictory exchange took place when Byrne was asked to comment on the fact that traffic was up ten percent plus, but the increase wasn't flowing to the top-line. He noted that sometimes traffic has surged in the past and conversions have lagged. Then he added, "But there is a mix issue in the traffic of where it could be for example, that some of the increase in traffic is coming from a source, which has historically low conversion. So that's going to give you an increase in traffic, but a decrease in conversion." Huh? So they have some profitable new marketing opportunities, but they are resulting in lower conversions (at least for now).

My interpretation is that they were dissatisfied with the results from search marketing, so they've shifted dollars from search to other channels, such as email marketing. They were getting a slight bump in traffic as a result, but the lower quality leads translated into lower conversions. The real problem is that now they're beginning to see traffic slow again.

As noted earlier, the key to making this business model work is getting the top line to grow (as margin expansion is not an option). Byrne said they're beginning to grow again, but are we to believe him? They couldn't grow last quarter and they were up against the Google penalty, the comp gets harder this quarter. Not only is the comp harder, but it appears that fundamentals have deteriorated further for Overstock intra-quarter. If you look at the Alexa data (traffic, reach, pageviews, time on site) they all show y/y deterioration for the current quarter. The company's problems would only be made worse if they are still experiencing issues with conversions due to the focus on non-search-related channels. This could lead to a continuation of the downward spiraling revenue we have witnessed over the last few quarters. If Overstock cannot grow the top line, it has little chance of being profitable for the year and its balance sheet woes will intensify.

Compounding Overstock's company-specific issues is the fact that the macro backdrop appears to be worsening. Home and garden made up almost 60% of Overstock's sales last year (10K pg. 4) and this category seems to be having some issues of late. Bed Bath & Beyond (NASDAQ:BBBY), Procter & Gamble (NYSE:PG), J.C. Penny (NYSE:JCP), Target (NYSE:TGT), and Scott's Miracle Gro (NYSE:SMG) have each provided recent proof. Many other retailers have also sounded alarm bells such that one might conclude the 2Q is going to be an uphill battle for most.

We also need to be cognizant of the festering issue around state sales taxes for online retailers, and Amazon's moves to pay these taxes and support the movement. State sales taxes are going to be a persistent thorn in the side for Overstock going forward. I suspect that forcing Overstock to pay these taxes would have an outsized impact on the retailer given the cut-rate nature of its business, and the type of customer that is attracted to its site.

The market continues to favor OSTK with high multiples and strong growth in projected earnings. My guess is that this won't last long.

Disclosure: I am short OSTK.