The Stalwart: The Case Against Overstock.com

Those looking for some short exposure in their portfolio should read some of Jeff Matthews' excellent blog as he has been on a one-man mission to expose what he sees as fraud and deception at Overstock.com (NASD: OSTK).

According to Mr. Matthews, the management team is totally dishonest, they put out misleading financial data, and the business stinks. In Stalwartian fashion he backs up his case with a close reading of the reports and lots of hard data.

Yesterday he gave a little preview of today's earnings report and explored some of the kinds of excuses they've given for past earnings failures:

But back to our earnings preview: Wall Street expects Overstock.com to report a $4 million-plus operating loss in the second quarter of 2005—about a million worse than the $3.4 million operating loss reported in the first quarter of 2005.

This is based on a modest sequential decline in revenues, a pick-up in gross margins, and far higher selling, marketing, administrative and technology costs than in Q1.

To the naïve observer, this losing-money forecast makes no sense, because in his first quarter 2005 letter to investors Patrick Byrne identified $7.9 million worth of supposedly one-time items that reduced first quarter earnings, without which the company would have been handsomely profitable.

(Byrne had done the same thing in the fourth quarter of 2004, identifying $6.5 million of one-time items that supposedly hurt reported earnings.)

The items enumerated by Byrne this time included a $1.2 million shipping promotion; a $600,000 blown electronics deal; a $1.2 million bonus accrual; $1.8 million to market an auction and jewelry site; $500,000 on technology consultants; and a $2.6 million “binomial marketing experiment” which apparently, like Frankenstein’s Monster, went horribly wrong before it could be killed.

(For the record, even though nobody listening to that conference call had the faintest idea what constituted a “binomial marketing experiment,” Wall Street’s Finest dutifully wrote down “binomial marketing experiment” in their word processors and sprinkled the howler throughout their research reports later that afternoon and in subsequent documents, without ever actually explaining what a “binomial marketing experiment” might be.

Note: Amusingly if you Google "Binomial Marketing Experiment" the first link you'll hit is an article from TheStreet.com. I'm not surprised that they, of all publications, would parrot this kind of nonsense.

On the Wall St. Analysts who talk about Overstock, Jeff Matthews has this to say from the same report:

One independent outlier expects far lower sales and somewhat lower earnings than the Street so we will ignore him for purposes of assessing "the consensus." The most bullish "consensus" analyst, as I can see, is Craig Bibb, who assumed coverage at WR Hambrecht in April, a few months after the previous analyst, Bill Lennan, cut his earnings and revenue numbers and took his price target from $85 to $60, helping spark a decline in the stock.

Bibb took over for Lennan with a buy rating and a decidedly cheery note in which he compared Overstock.com CEO Patrick Byrne to Olympic Ski Champion Bode Miller. I am not making that up.

Bibb further ingratiated himself with Overstock by writing that “Management is taking a dynamic approach to finding the efficient frontier of growth and profitability…,” precisely the kind of Wall Street lingo that makes sense only if you start your day sniffing glue. (emphasis added)

Apparently the CEO of Overstock has a knack for making mysterious deals, secretively acquiring large amounts of valuables at cut-rate prices. Only to find out later they don't work out so well:

The Mystery of the Pristine Inventory began in early 2004, when Byrne told investors:

“In the closing weeks of 2003 your chairman seized an opportunity to buy over $5 million of Franck Muller watches…they represent a sizable fraction of our inventory. Pick one, write me…and I’ll make you a deal.”

One year later, Byrne announced a large inventory clean-out, which cost the company $1.5 million.

“The dead inventory that I had accumulated over the years, both from my own bad buys and those that I let buyers ‘put’ to me, has been almost entirely flushed (including the Franck Muller watches).”

However, on the investor call the next day, he led investors to believe there was nothing left in the way of “dead inventory”:

"I decided in early December, let's just flush everything that has been around more than a few months. Our inventory has never been this clean. We just marked down, promoted, did whatever we had to do to blow out the older inventory. I lost $1.5 million on that inventory to move it all. But our inventory has never been this pristine."

It is not clear whether the inventory is “pristine,” as stated to the analyst community, or whether some “dead inventory” remains, as implied in his shareholder letter.

The answer may partly be found in the brief Case of the Forgotten Movie. Here, another big Byrne bet—a film called “FarenHYPE 9/11”—went from “a unique business opportunity” (10/21/04) to $700,000 worth of losses in just a couple of months (1/28/05).

And more:

Now, about that $8 million worth of diamonds.

After announcing the new site, and the price range he intends “to dominate,” Byrne went on to speak about what appeared to be the source of the diamonds being offered on “Build Your Own Ring”:

"We did a $7 million deal on diamonds that was the steal of a lifetime. Just fantastic pricing in there."

(How Overstock came to getting "the steal of a lifetime" on loose diamonds is another mystery, and not the subject of the Mystery of the 38 Diamonds. I take Byrne at his word that he somehow purchased $7 million worth of diamonds at an unusually attractive price, despite the fact that the diamond supply chain is tightly controlled, and not at all an inefficient market.)

Assuming an Overstock-type markup of 15% on those $7 million worth of diamonds, they would appear to be the same diamonds being offered for sale at the time of the launch.

So, how is "Build Your Own Ring" actually doing? Well, once again, it would appear, based on a careful monitoring of daily sales on “Build Your Own Ring” starting in late March, that reality indeed bites.

One diamond was sold March 29—price range $1,000 to $2,5000—and another on April 2, same price range. Then again on April 4, same price range.

Pretty slow.

But on or about April 7, something interesting happened: 38 diamonds vanished from the available inventory. I say “vanished” because it is impossible for an outsider to determine whether the 38 diamonds were sold, or otherwise removed from available stock. Either way, there were 38 fewer diamonds spread across various price points.

Furthermore, if the missing 38 were indeed sold, it is likewise impossible to determine whether they were sold one at a time to 38 different people—unlikely given that the previous single-day sales record tracked since March 24 had been a whopping one—or sold in a batch to a single buyer.

It is, however, possible to identify the price ranges from which the “missing 38” vanished: one was a $25,000+ stone; four were in the $17,500 to $25,000 range; four in the $10,000 to $12,500 range; six in the $5,000 to $7,500 range; and 23 in the $1,000 to $5,000 range.

Total value of the 38 diamonds newly missing: approximately $220,000.

It would be quite a coup for Overstock if the sudden vanishing of those 38 diamonds represented a sudden upsurge in ring-building on its “Build Your Own Ring” site. Going from the occasional one-a-day to 38 is exactly the kind of “tsunami” CEO Byrne once predicted for “Project Ocean.”

But just as suddenly as the 38 diamonds flew out the door one way or another, Overstock customers suddenly resumed building their own rings at a more measured pace—one more on April 8, in the $1,000 to $2,500 range. And none since.

Which makes the Mystery of the 38 Diamonds even more of a mystery than if those 38 were the start of something big.

There's quite a bit more on the company, and it would be silly to summarize all of it. Here is a list of all that he's written which you should definitely read through.

The stock is down over 5% today after they came out with another loss. I'm sure Jeff Matthews will be summarizing today's release which you should definitely read over.

For investors looking to add some short exposure to their portfolio, this might be the kind of thing to look for--weakness and problems. The Stalwart has learned the hard way, that overvaluation alone won't take down some very strong companies.

What is This?

The Stalwart is a blog written by Joseph Weisenthal, covering such topics as stocks, business, economics, politics, technology, gambling, chess, poker, economics, current events, music, math, Chinese food, science, randomness, kurtosis, sports, evolutionary fitness, and anything else of the author's choosing. The words contained herein are the author's own, not affiliated with any other firm or employer.

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