Skip to main content (OSTK) - Get, Inc. Report has been getting a lot of attention lately, but little of it focuses on the issues that really matter to shareholders. A closer examination of the online retailer's fundamentals reveals rapid revenue growth that has failed to yield profits, not an encouraging sign. In addition, Overstock's financial position may not be as strong as it may seem at first glance.

In our opinion, Overstock -- recently down 1.5% to $23.50 -- is best avoided ahead of its fourth-quarter report Tuesday morning.

Overstock secures inventory from retailers at discount prices, which it sells to consumers on its Web site. In its higher-margin fulfillment business, Overstock forms partnerships with retailers and manufacturers -- 380 third parties according to its 2004 annual report -- to sell products through its Web sites.

Overstock has experienced rapid revenue growth from these businesses, having generated $707 million in the 12 months ended Sept. 30 vs. just $25.5 million in 2001. (Overstock also runs an auction site, similar to


(EBAY) - Get eBay Inc. Report

, and operates in the travel business; neither is a meaningful revenue contributor at present.)

Unfortunately, this surge in revenue has not yielded much in the way of profits, due, in part, to a substantial increase in advertising spending. During the third-quarter 2005, sales and marketing expenses jumped 91% year over year to $17.96 million. The largest component of this expense was the $17.2 million the company spent on advertising, a 22% increase from the second quarter.

Sales were up 64% on a year-over-year basis and 12% sequentially to $169 million. While that's impressive on a stand-alone basis, the company posted an operating loss of $11.2 million, a loss 2.7 times wider than the year-ago period.

Things don't appear to be improving. On Dec. 27, Overstock lowered its financial expectations for the full year, saying that holiday sales were disappointing. Overstock said revenue would hit its target for an increase of 60% to 100% from year-ago levels, implying a revenue range of $790 million to $990 million. But the company said net income would be a percentage or two less than its prior target of break-even and operating cash flow will be negative.

The revenue range implies a growth rate far superior to most companies in our coverage universe, but without profitability, that growth means very little. This leads us to doubt whether Overstock can ever leverage its sales growth into operating income, let alone net income.

Unfortunately for Overstock, things have gotten worse at an inopportune time. The company ended the third quarter with its highest inventory balance in its history at $94.6 million, up 172% from year ago levels and 58% from the second quarter. In an effort to move this inventory off its books, Overstock offered free shipping for much of December, which will likely weigh on fourth-quarter margins and cash flow. In other words, Overstock made a very bold bet on outstanding sales for the December quarter, and we don't believe it will pay off.

As Overstock struggles to generate profits, the company's liquidity position takes on increased importance.

No Crisis, but Concerns

At the end of the third quarter, Overstock reported $2.6 million in cash and $74.2 million in marketable securities. The company finished the quarter with shareholder equity of $91.4 million. Overstock does not appear to be facing any near-term liquidity crunch.

However, we believe there are four elements of Overstock's liquidity situation that investors should focus on:

First, at the end of the third quarter, the company's cash balance (not including marketable securities, which we address below) was down to $2.6 million from the end of 2004 when, thanks to a $120 million convertible bond offering with a 3.75% interest rate, the company was flush with $198.7 million in cash. Since then, the company has purchased foreign corporate securities due to mature in November 2006 for $49.9 million and spent some $47.5 million on call options on its own stock to facilitate its stock buyback program. Additionally, Overstock has about $80 million in borrowings available under its two credit lines with Wells Fargo.

TheStreet Recommends

Second, Overstock's $74.2 million in marketable securities consists of $23.8 million in U.S. government securities and $48.2 million in the aforementioned foreign securities that do not have a stated interest rate. We are not convinced that this $48.2 million should be counted as a source of liquidity in its entirety because the debt is pledged as collateral for one of Overstock's bank lines with Wells Fargo, per the debt agreement's sixth amendment filed in October. However, when the foreign corporate securities mature in November, as much as $30 million of the proceeds could be required to be posted as collateral, thus reducing the useable cash portion to $20 million.

Third, the company announced a $50 million share buyback in January 2005, which was subsequently expanded to $100 million in April. We do not believe this is a wise course of action, considering Overstock is burning cash and increasing spending on sales and marketing efforts. By our count, the company has spent about $65 million buying back stock in the last year, which is a drain on cash flow.

Fourth, the interest rates on Overstock's lines of credit from Wells Fargo have been steadily increasing. The company's $40 million to $50 million loan and security agreement with Wells Fargo, entered into Dec. 12, had a rate of 1.25% to 1.75% above LIBOR, with a minimum of 3.75%, per its Oct. 18 amendment. That compares with just 1.35% above LIBOR for its other bank facility with Well Fargo.

Higher interest rates are often indicative of a bank's growing concern over a company's creditworthiness. Similarly, Overstock's convertible debt due in 2011 is trading at about 70 cents on the dollar and yielding 10.5%, a significant premium over comparable securities with similar maturities.

With most of its inventory and marketable securities pledged as collateral, and its book value shrinking and accumulated deficit growing, we believe Overstock will find it difficult to obtain additional financing. This is due to what we see as a weakening of its financial position and rising competitive pressures for all online merchants. In addition to other online retailers such as

(AMZN) - Get, Inc. Report

, Overstock faces heightened competitionfrom the e-commerce sites of traditional retailers such as


(WMT) - Get Walmart Inc. Report



(TGT) - Get Target Corporation Report

, as well as comparison shopping sites such as and bargain-finding sites like

At the end of the day, assessing a company like Overstock comes down to weighing the fundamentals against a seemingly attractive business model that just hasn't delivered yet. Investors keep expecting the next quarter or the next year to be the one when the numbers will improve, even in the face of continual disappointment. From what we see, that time remains far away.

Editor's Note: As previously reported, Overstock has sued Rocker Partners, which, as of Dec. 31, 2004, owned approximately 8% of the (TSCM) , accusing Rocker of conspiring with Gradient Analytics, a research firm, to drive down its share price. Rocker and Gradient have denied wrongdoing. The matter is being investigated by the Securities and Exchange Commission.

The TSC Breakout Stocks Team is Michael Comeau and William Gabrielski, research associates at In keeping with TSC's editorial policy, they don't own or short individual stocks. They also don't invest in hedge funds or other private investment partnerships. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. For more information about Breakout Stocks, please

click here.