Mike Price sends: In keeping with this trend of using the Warren Buffett Way to evaluate all my investments, in this post I’ll look at Overstock (OSTK).

Business

Simple and Understandable
Overstock sells the overstocked goods from other companies on its website. Part of its revenue comes from inventory Overstock buys from companies, the rest comes from ‘partner’ revenue where companies sell their inventory on Overstock’s site and Overstock gets a commission.

Consistent History
Not even close. After Overstock started it had extreme revenue growth for a few years, then Byrne got distracted and the company went to hell with negative revenue growth, currently it has come to kind of a stand still while the company attempts to turn-around.

I believe that when Overstock become profitable earnings growth will be huge for a few years then it will grow consistently over time.

Long-Term Prospects
There is a lot of uncertainty here which is a big part of why the stock price is so depressed.

I believe the company has good prospects and has already started a great turn-around. Profitability will serve as a catalyst for Overstock’s business and share price in the future.

Revenue growth looks like it has dimmed over the past few years, but as the company fazes out the direct portion the total growth will fall to pave the way for the much higher returning partner revenue, which has grown 20% in the last two years - most of that coming over the last year when Byrne really got his head back in the game.

Management

Rational
This one could be looked at as so-so.

Byrne has a lot of expectations and a lot of lofty goals in turning-around the company, but so far I believe he has done well meeting his expectations and communicating the progress to shareholders.

Candid
Byrne could be called the best CEO for a shareholder because of his fight against hedge funds that drove down the stock price, but I believe the best CEO is the one who runs a very profitable business and returns the cash to shareholders.

Since, Overstock has yet to be GAAP profitable he hasn’t been able to do this, but I do believe he is extremely candid detailing his turn-around plans to shareholders and teaching how his metrics for evaluating the company should be used.

Resists Institutional Imperative
If there is a CEO who resists the institutional imperative the most it is Patrick Byrne, he could not care less about what any analysts care about him and has routinely let them know.

Financials

Return on Equity
Overstock is not yet profitable, but because of its great partner business (which has a working capital model like Dell or Costco where it receives the cash for sold products within a week, but doesn’t have to pay the company for a month) just a 1% profit margin would bring a 28% Return on Equity were they to achieve the margin of Amazon (very likely in a few years) of 3.2% it would have a return on equity of 90% (its likely by this point the company would have had to invest more money into the business and there would be more equity, revenue growth may or may not keep up with the capital growth).

Owner’s Earnings
Overstock does not have positive Owner’s Earnings, but it the trailing twelve months it produced $10 million in operating cash flow, while paying $2.6 million in capital expenditures - this is free cash flow of $7.4 million.

Profit Margin
Overstock’s profit margin is currently negative 6%. The company currently has a 17% gross margin, which is low, but has been increasing and the new focus is on trimming down costs. This margin should reach 20-23% .

The company also paid 15% of revenue on technology and marketing expense - costs that will fall as the revenue increases.

Moat

Shoppers
Overstock is a more shopper friendly site than most. At Amazon you know what you want and go search for it then buy it. Overstock’s site is geared more towards the shopping experience, of looking through all the deals for the day and things on big sales.
It has a more random selection of items then Amazon, because it’s all overstocked stuff. It would be like going to a thrift store (in Utah it would be like going to DI, I guess in other parts of the country it’s like Tuesday Morning or Big Lots) where a lot of the fun is in just shopping and looking around for good deals.

This is the main reason my Mom and Grandma like looking through it. About a year ago they were looking for a rug for a house in Chicago where my Grandma lives, they could never find one that they liked in combination with the best price, but when my mom looked on Overstock she found a good rug they both liked for a fraction of the price and low shipping costs. They were afraid it would take weeks to get to the house, but it was there inside one.

There are tons of stories like this, it is the reason women love the site, and probably the reason Wall St. doesn’t understand it. Hoping she won’t read this, I’ll add that I think my mom may be addicted to Overstock. We get 3-4 packages a week, but we actually save money because the stuff that is purchased is at a huge discount, and shipping is low.

Customer Service
This used to be a huge problem for Overstock. Because they sell the overstocked inventory, there can be a lot of stuff wrong with it. In the past their customer service was not friendly and generally pissed people off.

But, Byrne re-vamped the whole thing and they have been in the top five of the American Express customer service survey each of the past two years. This great customer service allows them to take an angry customer, make her happy, then make her want to come back to the site and buy more.

The Ultimate Question: Driving Good Profits and True Growth
I’m not sure when exactly Byrne read this book, but for the past year or two he’s been updating Overstock’s progress on it in the conference calls. I won’t go deeply into the mechanics of the book - that would take a whole post on its own - but the gist of it is:
A company can never be successful if it does not make customers happy. When customers are happy they become promoters of the store and tell all their friends to go there.
The book is about the Net Promoter Score, the author found that companies with high Net Promoter Scores, like Harley Davidson (HOG), eBay, or Costco (COST), can use their customers to fuel growth.

Byrne has been changing Overstock to become a Net Promoter and has been tracking its progress on the conference calls, it is currently not as high as the great companies like Harley Davidson, but is doing better than the majority of US companies.

A Different Brand
Overstock does not have as valuable a brand as Amazon, but it does have a valuable brand. Overstock has spent a lot of money since it was started (ironically it spent a lot less than Amazon did to get to a similar revenue level) to develop its brand through marketing and technology expenses.

As before stated, Overstock is where you go to shop and find random, under-priced stuff.

Better than eBay for Stores
Overstock doesn’t really compete with eBay (though it does have an auction site that isn’t nearly as big as eBay so we’ll ignore that here), because it isn’t logical for companies to sell their inventory on eBay.

If it sells it on Overstock, Overstock collects the money and takes the risks.

On eBay it would have to use Paypal and deal with every customer individually.

Lets say Nike has a bunch of shoes it can’t sell. If it goes to sell them on eBay it will have to make its own page for them - and one new page for each separate item it wants to sell. Then they hope enough people search eBay for Nike shoes to buy all of them. Most people on eBay think they are buying something from someone like themselves so they will want a low price and will bid for a low price. Then when someone buys the item, Nike will have to deal with that person’s PayPal address (usually), collect the money from them, and then send the shoes. Basically, they do all the work, then eBay takes a commission. If the person doesn’t like the shoes, they call Nike directly and Nike has to pay more for customer service, then Nike has to refund the person separately through the Paypal account, then get the shoes back from the customer, who may not buy Nike shoes again because the customer service might be bad since Nike just had to start this new division.

If Nike used Overstock it would call them up say, “Hey, we’ve got a bunch of shoes we need to sell.” Overstock then puts the item up on their website, and promotes it in the deal of the day, because of this a lot of customers see this and buy it. Overstock takes the money from the customer and deals with all the processing etc. (with eBay they have to pay a commission to eBay and to Paypal). Then Overstock tells Nike where to send the shoes, covering the cost of the shipping and Nike does. Overstock then sends the money to Nike, in this case Overstock did the work and then took a commission. If the customer doesn’t like the shoes they call up Overstock - who has award winning customer service - and Overstock gives them their money back.

First Mover
Overstock is the first mover and by far the top-dog in the online liquidation business. They have spent hundreds of millions developing their brand and relationships with suppliers over the past nine years to set themselves up as a player in online shopping.

Because of Overstock’s culture of cutting costs, a potential competitor would have probably have to pay more than they did to set-up a comparable site, get relationships with suppliers, and turn their customers into promoters. Since that company would likely lose a lot of money in the first bunch of years, Overstock would have the high ground in defending their castle.

Valuation
This can be called a crap shoot with Overstock. It’s very easy to say they are since they trade for 2/5ths of sales.

But, since the occurrence of profitability is unknown pinning an exact value on Overstock is very difficult.

In an attempt to remain simple I have valued it in two ways:
-If Overstock can grow revenue 15% over the next two years, and achieve 2% profitability it would have $17.5 million in earnings, a 20x multiple on this is $350 million, add net cash of about $25 million and you have a market cap of $375 million, this is a 44% increase or 18% per year. I believe the 20x multiple is conservative because at this point the company will have ~56% return on equity, will have killed Wall St. doubts of its profitability and will have the benefit of millions of shares currently sold short being bought back.
-Secondly, I believe a sophisticated businessman or company would easily pay 1x sales for Overstock, because of its wide moat in the online liquidation business and the potential for a high return on capital, this equates into a $760 million dollar market cap which is a 192% return.

Conclusion
In conclusion, Overstock is a classic Mohinsh Pabrai investment, the company is low risk - it has great relationships with partners and a big moat keeping its customers and is well on the way to achieving profitability as proven by it positive free cash flow, plus the stock priced is depressed to the point that it’s trading for less than half of sales - but has high uncertainty - Wall St. thinks it will never become profitable.

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