Overstock Is on Discount

This column was originally published on RealMoney on March 13 at 11:16 a.m. EST. It's being republished as a bonus for TheStreet.com readers.

Over the past year there has been an avalanche of negativity about Overstock(OSTK). The company has been criticized for underperforming analyst expectations in 2005, and there has been a swirl of controversy surrounding Patrick Byrne, CEO of Overstock, and his legal battle over alleged front-running by certain hedge funds.

My review of the financial statements and operating history of Overstock indicates that the negativity is overdone. This is a severely undervalued company.

As I'll explain below, my minimum prospective value for Overstock shares is $92 in 2010; it currently trades at about $23.

Overstock's business is not complicated -- it's the online equivalent of an outlet mall. The excess inventory segment of the retail market is ideally suited for the Internet. Brand-name manufacturers can avoid the inefficiencies of supplying and staffing retail outlet stores by partnering with an online aggregator like Overstock.

Also, excess inventory levels are notoriously irregular and difficult for manufacturers to manage. They have to deal with unpredictable change in both the nominal level and across product categories. Using a single distribution partner, like Overstock, requires no capital outlay by manufacturers and results in fast conversion of excess inventory to cash.

Here's the key analytical point for this particular model: The online space that Overstock competes in is a winner-take-all category. Like with eBay(EBAY) in the online auction space, there's a self-reinforcing dynamic at work here. Buyers naturally migrate to the inventory liquidation site that has the most product, and sellers want to sell on the site that has the most buyers. It's a mistake to underestimate the importance of this dynamic -- or its potential long-term value.

Financial Statements Paint the Picture

The financial statements of Overstock tell an impressive story. Annual revenue has grown from $92 million in 2002 to $239 million in 2003, to $494 million in 2004, and to $804 million last year. Most remarkable is that this robust revenue growth -- soon to be over $1 billion per year -- has been accomplished using a minimal amount of capital.