Controversy Dogs Overstock.com

Wall Street can't seem to determine whether Overstock.com ( OSTK) is the next eBay or another looming dot-com disaster.

The company's stock is up 58.4% this year and set a record high earlier this month. But the gain appears to be mainly the result of a short squeeze, and many investors and analysts remain sharply critical of the company and its prospects.

"I'm not a believer that these guys are going to make money," said Rob Wilson, who covers the company for Tiburon Research Group.

Last year, Overstock's profits declined even though its sales skyrocketed, Wilson noted. "That flies in the face of the conventional wisdom as to what everyone thought was going to be the case here." (He does not own Overstock shares and Tiburon does not do investment banking.)

Predictably, CEO Patrick Byrne was more sanguine about the company's recent results, noting Overstock losses in recent quarters are far less than those of rival Amazon.com ( AMZN) when it had similar revenue.

"We should come within a percent of breakeven this year," Byrne said in a recent interview with TheStreet.com. "If we can keep it up, at some point -- people can doubt all they want -- but at some point, they're going to have to give credit to the franchise we've built."

Last month, Byrne put his money where his mouth is, spending some $12.8 million to buy 620,000 shares of Overstock, according to regulatory filings. Byrne now beneficially owns some 6.8 million shares of Overstock, or about 40.6% of the company.

Byrne's move came as investors were shorting some 44% of the company's public float, according to Yahoo! Finance. His purchase amounted to nearly 80% of the company's average daily trading volume, prompting many short-sellers to cover their bets and buy shares. Notably, Overstock shares are up 60% since Byrne's move.

Byrne acknowledged being aware of the heavy short interest in Overstock shares at the time of the purchase, but denies trying to squeeze short-sellers.

"I bought the stock because I thought it was a good deal," Byrne said. "Reality is going to tell us who's right and who's wrong."

For a number of investors and analysts, Overstock's operating performance already shows what's wrong with the company.

Rising Sales Lag Expenses

Soon after the company launched, Byrne showed reporters and investors a chart projecting steadily decreasing losses that led inexorably to fast-growing profits. As recently as the fourth quarter of 2002, the company seemed to be well on its way to meeting that expectation, when it posted its first-ever net profit.

However, the company's results soon diverged from the pretty parabola as Overstock.com posted a worse-than-expected first-quarter result last year and a worsening bottom line in the third and fourth quarters.

All told, the company went from generating $2.5 million in cash from operations in 2002 to seeing an operating cash outflow of $10.4 million last year. That cash drop came despite what would have been a 91% gain in sales last year if not for an accounting change.

The problem Overstock faced was that its expenses grew far quicker last year than its fast-paced revenue. For instance, the company's product and fulfillment costs soared 191% in 2003 to 89.3% of sales, while advertising costs grew 165% to $18.5 million.

"You've seen what happened, they built volume and their margins have gone to hell," said one hedge fund manager, who is short the stock and asked not to be named. "The bottom line is their business model doesn't work."

Byrne, of course, has a different take. The company's sales started to stall last year because of a drop in inventory, he said. Overstock poured money into marketing to jump-start its sales last year. Now that the company's sales are back on track, marketing expenses should start to decline as a portion of revenue. And Overstock's bottom line should again approach profitability, he said.

"You're getting us right at the moment where we gunned it," Byrne said, comparing Overstock to a speed boat or a sea plane. "That moment looks like we're using a ton of fuel for the speed that we've attained."

But Overstock may not have long to get back up to speed. The company's operating problems could soon lead to a cash crunch, skeptics warn.

Despite its worsening loss, Overstock's cash balance actually jumped 161% last year to $28.8 million as of Dec. 31. But much of that jump came from a public offering in February last year that raised $24 million. Meanwhile, the company's accounts payable balance swelled 121% to $30.4 million at the end of last year.

In its annual report, the company said its cash balance dipped to less than $10 million at one point in the fourth quarter. Byrne said the company saw its cash balance dip by $15 million to $20 million in January as it paid down its payables balance.

Skeptics say the company's cash balance could become a critical factor later this year when Overstock needs to start buying inventory for the holiday season.

"He would be out of business if he can't buy inventory," said one buy-side analyst, who also asked not to be named. "The only way they'll be able to afford that inventory is by raising more capital. That's the reality that no one points out. This is a business that burns cash and needs more cash to stay in business."

The company appeared to acknowledge its need for more cash last month, when it filed a shelf registration, proposing to raise up to $64.5 million by selling some 2.5 million shares.

But Byrne hopes not to tap into the public markets again so as to prevent further diluting shareholders. Overstock's third-party sales generate cash because the company sees revenue from such sales immediately, but doesn't have to pay vendors until 15 or 30 days later, he noted. As the company's sales grow, that third-party cash should swell, he said.

Byrne acknowledged that the company will likely need cash for the holidays. But Overstock has established a line of credit with a bank that it plans to draw on during the holidays. That may obviate the need for another public offering, he said.

"It's not clear whether we will need more cash or not," Byrne said. "There's the prudential argument, to put extra cash away, that's just the prudent thing to do. But I'm not in a real hurry to pull the trigger on that."

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