Breaking Down the Overstock Discount

Overstock's gross margin growth has been exceptional over the last couple of years, with the nominal level growing from 9% to over 15%. The gross margin growth compares favorably (it's a bit better) to Amazon, a company with a remarkably similar operating structure. Note that certain fulfillment expenses are reported differently by Amazon, so an adjustment is needed before making a comparative analysis.

Amazon is a couple of years ahead of Overstock in its model maturation process, and the earnings leverage power explained above already has dropped to Amazon's operating line, with operating margins improving from negative 13%, to positive 7%, in a relatively short period of time.

The Market Opportunity for Overstock Is Huge

The addressable excess inventory market is over $60 billion. Most of this market is currently offline, with distribution via a highly fragmented, inefficient traditional retail network. Partnering with Overstock is an appealing alternative for suppliers because it requires no capital, solves the irregular inventory issue (discussed in last week's column), and results in a fast conversion of excess inventory to cash.

Over the next eight to 10 years, it's reasonable to expect that Overstock will secure at least 10% of the addressable market. That translates into $6 billion in sales for Overstock, assuming a static total market.

As I said in my first column, a 1 times sales valuation is conservative for this model, given the earnings leverage and capital efficiencies. As the Overstock model matures, valuation may move closer to 1.25 to 1.5 times sales. Amazon commands a 1.8 times sales valuation, a reasonable value given its still-to-be-unlocked earnings leverage and dominant market position. The current market value of Overstock is $527 million, or 0.58 times sales.

Look for Part 2 of this column later this week. I'll review the negativity surrounding Overstock on the issues of liquidity and management.

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