Breaking Down the Overstock Discount

Overstock's market dominance is evidenced by its explosive growth in sales --- about a 10-fold increase in four years --- from $92 million in 2002 to about $900 million anticipated in 2006, based on conservative assumptions. Most impressive is that its "category capture" was accomplished using a tiny amount of capital.

Any analyst that carefully studies the numbers has to cede this point.

The numbers are jaw-dropping. Overstock has built a business with $900 million of sales (2006) while deploying just 7 cents of capital for each dollar of revenue. I can't find another retailer that comes close to this metric. At a similar point in its history, Amazon(AMZN Quote) needed 70 cents of capital for each dollar of revenue.

Traditional retailers can't come close to the 7-cent standard set by Overstock because physical stores require more capital. Still, it's interesting to study their operating structures. For example, Starbucks(SBUX Quote) deployed $1 of capital to generate $1 of revenue when it neared the $1 billion mark in sales, a level of sales that Overstock is close to now.

Implicit in the criticism that "Overstock is losing millions" is the idea that a loss in accounting terms correlates to a loss (or a diminution of value) in economic terms. That is a false construct. Coincident with an accounting loss, it's entirely possible to generate a huge gain in economic value (and vice versa).

I'll let some other analyst calculate the economic value of the No. 1 position in the online excess inventory category. It's safe to say that it is considerable, and that the minimal accounting loss incurred to capture this category (an average 3% operating loss) translates into a superb return on investment. It compares favorably to Amazon's average 20% operating losses at a similar point in its history.

The Magic of Earnings Leverage

Study the operating history of every great organic growth company and you'll see a common thread that weaves through each model. Without exception, the maturation of each model unleashes enormous earnings leverage. The source of this earnings "magic" is simple: Sales grow faster than costs.

For both magnitude and velocity of earnings change, the Overstock model is much more powerful than a traditional retail model. That power follows a predictable path. First, it is observable in the top line. A traditional retailer simply can't muster a 10-fold gain in sales in four years, as Overstock has done. After sales, it is manifested in rapid gross margin expansion followed by operating margins and then the bottom line, or earnings.