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Overstock.com: Business Strategy Analysis. Case Overview. Comprehensive case that we will use throughout the course Rapidly growing “e-tailer” Strong sales growth and high stock price valuation But struggling to report a profit. Overview of Business. Close-out Internet retailer
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Case Overview • Comprehensive case that we will use throughout the course • Rapidly growing “e-tailer” • Strong sales growth and high stock price valuation • But struggling to report a profit
Overview of Business • Close-out Internet retailer • http://www.overstock.com • Revenues grown from $2 million in 1999 to $200 million in 2003 • Offers 12,000 non-BMV products and 500,000 BMV products • Reported losses for each of the last 3 years
Summary of Business Strategy • Key Success Factors • Utilization of Internet to aggregate supply and demand and create a more efficient market for liquidation merchandise • Single point distribution • Resolution of channel conflict (different sales channel prevents cannibalization of regular sales) • Strong relationships with manufacturers • Good inventory management, distribution and customer service • First mover advantage => economies of scale; brand recognition
Summary of Business Strategy • Key Risks • Competition from established competitors (Amazon.com, SmartBargains.com) and new entrants • Inventory obsolescence risk (direct business) • Risk associated with sales returns (direct and fulfillment business) • Growing too quickly and losing control of operations and costs • Key personnel, particularly Patrick Byrne • Suppliers start their own liquidation websites • Regulatory costs associated with taxes, pirating, fraud etc. • Can’t access capital required to execute growth strategy
Overall Evaluation of Overstock’s Business Strategy • Currently characterized by rapid growth, but no profits • Competition is high, so it will be difficult to establish a sustainable competitive advantage • Are they selling products to cheaply? or • Are they investing in developing a first-mover advantage that will generate sustainable competitive advantage?
Key Takeaways • Do not assume that rapid sales growth reflects a viable business strategy. It is easy to grow when you are selling something for less than it costs. • Good ideas are easily imitated in a competitive industry • Economies of scale can create a first-mover advantage that may lead to sustainable competitive advantage
Critical Accounting Policies • Revenue Recognition • Major switch from commission basis to gross basis for fulfillment partner revenue on July 1, 2003 • Reserve for Returns • Allowance for Doubtful Accounts • Allowance for Obsolete and Damaged Inventory • Accounting for Income Taxes • Valuation of Long-Lived and Intangible Assets and Goodwill
GAAP Basis vs. Gross Basis Sales (see Gross to GAAP reconciliation at the top of page 32 of Form 10-K)
Sales Growth • Growth rate in GAAP basis sales = 238.9/91.8 = 160% • Growth rate in gross basis sales = 278.8/142.8 = 95%
Gross Profit Growth • Growth rate in GAAP basis gross profit = 25.3/18.3 = 39% • Growth rate in gross basis gross profit = 25.3/18.3 = 39%
Accounting Performance vs. Economic Performance • Overstock.com is ‘investing’ significant amounts to fuel sales growth, customer loyalty and brand awareness. Most of these amounts must be immediately expensed for accounting purposes: • Sales and marketing expenses • General and administrative expenses • Loss-leading margins on BMV merchandise
Key Takeaways • Subjective accounting choices can produce significant distortions to sales growth rates and profit margins. Make sure you are aware of such distortions before interpreting the information in the financial statements • GAAP requires the immediate expensing of many expenditures that are potentially investments that could lead to future benefits. Thus, lack of profitability does not necessarily imply a flawed business model.
Trade-Off 1:Internet versus Bricks and Mortar Bricks and Mortar Internet
Trade-Off 2:Liquidation versus Regular Retail Liquidation Regular Retail
Trade-Off 3:Direct versus Fulfillment Partner Fulfillment Partner (Commission-Basis) Fulfillment Partner (Gross-Basis: we take returns) Direct Fulfillment Partner (Gross-Basis: they take returns)
Trade-Off 4:Discount Retailer versus Department Store Department Store Discount Retailer
Overall Evaluation of Trade-Off May Department Stores Ross Stores Amazon.com Overstock.com
Key Insights from Analysis • Overstock’s turnover looks a little slow • High balance of cash and marketable securities slows down aggregate turnover ratios • Aggressive use of fulfillment partners combined with gross-basis accounting for sales revenue should lead to higher turns than Amazon.com • Overstock’s margins are currently way too low • Margins lag way behind competitors • Partly due to accounting distortions resulting from immediate expensing of SG&A in a rapidly growing company • For long-term viability, gross margin needs to be in mid/high teens and operating expenses need to be in low/mid teens
Overstock.com:Forecasting Analysis(Using Q3 2005 – see spreadsheet for details)
Forecasting Overview • Illustrates systematic framework for generating financial statement forecasts • eVal will walk you though this framework moving forward • Starting point is historical financial statements • Sales growth, margins, turnover ratios, leverage • Use insights generated from your analysis of the past to modify forecasting assumptions • Business analysis • Accounting analysis • Financial analysis
The Forecasting Process Forecast Sales Forecast Operating Margins Forecast Turnover Operating Expenses Operating Assets and Liabilities Interest Expense Forecast Leverage Tax Expense Balance Sheet Income Statement Statement of Cash Flows
Sales Growth • Sales growth rate for: • Q3 2004 = 79% • Q4 2004 = 80% • Q1 2005 = 102% • Q2 2005 = 72% • Guidance in 9/16/2005 press release “Investors should note that our restricted ability to post fresh inventory slowed sales sharply, a caesura from which we are now rebounding. In addition, the upgrade also caused inefficiencies that, when combined with our extended dollar shipping promotion, has put downward pressure on gross margins this quarter. However, my goal of growing 60% to 100% for the year at break even GAAP, +/- 1%, stands."
Margins & Turnover • Gross margin lower based on guidance from 9/16/05 press release • Technology expense higher due to information in press release • G&A expense higher due to information in press release • Inventory/Sales up due to information in press release • PP&E/Sales up due to tech upgrade • Goodwill up $25 million for Ski West Acquisition (see press releases 6/24/05 and 7/1/05) • Accounts Payable/Sales down due to information in press release
Leverage and the Balance Sheet Plug • No indication that OSTK issued/repurchased any common equity during Q3 ’05 • No indication OSTK issued/retired any debt during Q3 ‘05 • I assume that OSTK funds cash shortfall for the quarter by selling marketable securities
Analyst Valuation Method • Analyst report uses comparable enterprise value to revenue multiples with ‘discount retailing peers’ and ‘internet bellwethers’ as comparisons • Argues that OSTK deserves a premium because of superior top-line growth prospects • Note that enterprise value equals market value of equity plus book value of debt less cash and short-term investments
Problems with Analyst Valuation Method • Implicitly assumes: • OSTK can generate similar margins to comparison companies • OSTK’s top-line sales growth will translate into bottom-line EPS growth, but OSTK is currently generating losses on its sales. In the long run, OSTK must generate ROE > r for growth to generate value
Default eVal Valuation • Default valuation is less than -$4,000/share! • Default valuation extrapolates Overstock’s artificially high 2003 sales growth rate of 160% for 10 years into future • Default valuation extrapolates Overstock’s 2003 ROE of around –25% for the infinite future • Default valuation model assumes that Overstock will continue to lose money forever, but that investors will keep pumping new money into the business to cover these losses! (see cash flow analysis) • In reality, company will either turn to profitability in the not too distant future or go out of business
eVal Assumptions for $30 Valuation • Valuation Parameters • Valuation date = 03/10/2004 • Cost of equity capital=10% • Forecasting Assumptions • forecast horizon = 10 years • Trend sales growth rate from 90% to 5% • Trend COGS/Sales from 88% to 86.3% • Trend SG&A/Sales from 15% to 10% • Trend Depreciation Rate down to 25% • Set Interest Rate to 8% (=cost of debt) • Trend Non-operating Income/Sales to 0% • Set tax rate to 36% for terminal year (leave at 0 for all prior years) • Trend Operating Cash/Sales to 3% • Valuation=$31.76
Plausible Valuation Assumptions • Valuation parameters • Valuation date = 03/10/2004 • Cost of equity capital = 10% • Forecasting Assumptions • horizon to 5 years • Trend sales growth rate from 90% to 5% • Trend COGS/Sales from 88% to 86.3% • Trend SG&A/Sales from 15% to 10% • Trend Depreciation Rate down to 25% • Set Interest Rate to 8% (=cost of debt) • Trend Non-operating Income/Sales to 0% • Set tax rate to 36% for terminal year • Trend Operating Cash/Sales to 3% • Valuation=$9.64
Key Takeaways • Naïve use of comparable valuation multiples can be used to justify implausible valuations. It is important to understand the implicit assumptions in the use of comparable valuation multiples. • Growth and ROE interact to determine value • Terminal ROE must climb above cost of capital for business to be viable • OSTK operates in a highly competitive environment, so terminal ROE is unlikely to be more than 15% • Given a terminal ROE of 15%, the horizon over which OSTK can continue to grow at abnormally high rates is the key determinant of value
