Doing the Math on Overstock

It's irrefutable that Overstock has generated significant organic growth. The company's 2002 sales were $92 million, and sales this year will exceed 10 times that, or over $920 million. While I estimate that the Overstock model will eventually mature at a free cash flow margin of 3.5% of sales, it may be materially higher.

When Home Depot (HD - commentary - Cramer's Take) was generating 3.5% to 4% net margins several years ago, analysts (including me) failed to identify the earnings leverage in the model that resulted in 7% margins. It's quite impressive that Dell (DELL - commentary - Cramer's Take) can sell a low-margin commodity product and generate well over 6% net margins (up from less than 2% in the early years). If I had been given Dell's operating metrics in the early days, my guess is that I would have estimated, at the very most, an ultimate net margin level of only 3% or so.

The most powerful earnings leverage is found in operating models, like those discussed above, where there is a combination of both organic growth and category dominance. Because Overstock has both organic growth and dominates a winner-take-all online category, it's reasonably likely that I have underestimated its long-term profitability.

Because of the way earnings leverage works, the transition from losing 2 to 3 cents to earning 3 cents or more per dollar of revenue requires nothing heroic for Overstock. At $1 billion in sales, the company generates $150 million in gross profit dollars. (I consider a 15% gross margin a conservative assumption.) At $2 billion it generates $300 million, and at $4 billion generates $600 million. Costs such as marketing, technology and G&A (general and administrative) grow in nominal terms, but not as a percentage of sales.

Think of technology and G&A as the cost of "headquarters." Much of that cost is front-end loaded. While headquarters will cost more at $2 billion in sales than it does at $1 billion in sales, it will not cost anywhere near twice as much.

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At time of publication, Alsin and/or ACM was long Overstock and Home Depot, although holdings can change at any time.

Arne Alsin is the founder and principal of Alsin Capital Management, an Oregon-based investment advisor, and portfolio manager of The Turnaround Fund, a no-load mutual fund. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Alsin appreciates your feedback; click here to send him an email.