Value Stock Investing: CarMax, Overstock.com

Overstock.com

Overstock.com's (OSTK) stock is woefully undervalued because the market has failed to recognize the cash-generating capability of its conduit operating model. More than 80% of the business involves excess inventory sold by Overstock that is shipped to the customer directly from third-party fulfillment partners. This type of model is highly prized because it requires almost no cash to operate and grow. Once a conduit model starts to generate cash earnings, rates of return on metrics like invested cash and net capital soar to levels that 99% of existing companies cannot match.

The company's GAAP [generally accepted accounting principles] earnings mask the real story here. That's because the company overbuilt its infrastructure in recent years; as a result, noncash expenses such as depreciation are out of sync with capital expenditures. Investors have failed to properly adjust for the unusually high depreciation expense, an expense that will be in sync with capital expenditures in a couple of years. Meanwhile, investors should focus on cash earnings. I expect $25 million to $30 million in cash earnings this calendar year on sales of $1 billion.

How much is this stock worth? A valuation of 1 times revenue is based on my expectation that the company can deliver at least 3% net margins over the next two to three years (on a cash basis). A key variable in the valuation analysis is sales growth in the "partner" business (the conduit business). Last quarter it was 33%. Currently worth $40 a share at 1 times revenue, the company will be worth double that in two years if the recent growth trajectory continues. That doesn't include any premium for sales growth. If the company can maintain recent sales momentum, some sort of premium is warranted. It recently traded at $20 a share.

This column was originally published on RealMoney on May 13, 2008 at 9:29 a.m. EDT. For more information about subscribing to RealMoney, please click here.

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