This column was originally published on RealMoney on March 20 at 11:02 a.m. EST. It's being republished as a bonus for readers.

It doesn't require a lot of effort to follow the crowd when investing in the stock market. You don't have to think independently. You don't have to ask a lot of questions. You don't have to carefully consider and evaluate data.

It's particularly easy to follow the crowd when negativity is involved. The easy path is to accept negativity at face value. The difficult path is to sort through the criticism and compare it to relevant data in an effort to distinguish fact from fiction.

As I said in my column on Overstock ( OSTK) last week, despite an "avalanche of negativity," this is a severely undervalued stock. The criticism directed at Overstock revolves around three issues: earnings, liquidity and management.

In this first installment of a two-part column, I begin a detailed look at these issues.

'Overstock Is Losing Millions'

My review of the Overstock operating model and competitive moat indicates that this oft-repeated criticism is misleading. Earnings are a minor variable in the value equation at this juncture in the company's history. Market share is the critical variable. That's because this company is on the cusp of capturing a winner-take-all retail category.

The excess inventory category is similar to the online auction category. The No. 1 player in this category, once they become entrenched, is set up to dominate for a very long time. In online auctions, it's eBay ( EBAY). In excess inventory, it's Overstock.

Traditional bricks-and-mortar retailers engage in a competitive battle from town to town, from one community to the next. A traditional retailer like Borders ( BGP) may grab a competitive advantage (e.g., the best location) in one town, while Barnes & Noble ( BKS) may gain the upper hand in the next town.

In the case of eBay and Overstock, though, there aren't hundreds of competitive skirmishes spread across the country. There is only one battlefield, in just one town -- the online community. It's sobering to consider the stakes in a winner-take-all online contest. You either win the No. 1 position early in the game, or you're destined for oblivion.

Consider some of the names that jostled for position in the early days in the excess inventory space. Some of these companies had access to much more capital than Overstock, but now they're just "also rans": Ubid, eCost, Smartbargains,, Mercata, Andy's Garage and MobShop.

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) 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) 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.

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.

P.S. from Editor-in-Chief, Dave Morrow:
It's always been my opinion that it pays to have more -- not fewer -- expert market views and analyses when you're making investing or trading decisions. That's why I recommend you take advantage of our free trial offer to's RealMoney premium Web site, where you'll get in-depth commentary and money-making strategies from over 50 Wall Street pros, including Jim Cramer. Take my advice -- try it now.
At time of publication, Alsin and/or ACM was long OSTK, although holdings can change at any time.

Arne Alsin is the founder and principal of Alsin Capital Management, an Oregon-based investment advisor, and portfolio manager of The Turnaround Fund, a no-load mutual fund. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Alsin appreciates your feedback; click here to send him an email.

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