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Overstock.com: Business Strategy Analysis

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Overstock.com: Business Strategy Analysis Case Overview Comprehensive case that we will use throughout the course Rapidly growing e-tailer Strong sales growth ... – PowerPoint PPT presentation

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Title: Overstock.com: Business Strategy Analysis


1
Overstock.comBusiness Strategy Analysis
2
Case Overview
  • Comprehensive case that we will use throughout
    the course
  • Rapidly growing e-tailer
  • Strong sales growth and high stock price
    valuation
  • But struggling to report a profit

3
Overview of Business
  • Close-out Internet retailer
  • http//www.overstock.com
  • Revenues grown from 2 million in 1999 to 200
    million in 2003
  • Offers 12,000 non-BMV products and 500,000 BMV
    products
  • Reported losses for each of the last 3 years

4
Summary of Business Strategy
  • Key Success Factors
  • Utilization of Internet to aggregate supply and
    demand and create a more efficient market for
    liquidation merchandise
  • Single point distribution
  • Resolution of channel conflict (different sales
    channel prevents cannibalization of regular
    sales)
  • Strong relationships with manufacturers
  • Good inventory management, distribution and
    customer service
  • First mover advantage gt economies of scale
    brand recognition

5
Summary of Business Strategy
  • Key Risks
  • Competition from established competitors
    (Amazon.com, SmartBargains.com) and new entrants
  • Inventory obsolescence risk (direct business)
  • Risk associated with sales returns (direct and
    fulfillment business)
  • Growing too quickly and losing control of
    operations and costs
  • Key personnel, particularly Patrick Byrne
  • Suppliers start their own liquidation websites
  • Regulatory costs associated with taxes, pirating,
    fraud etc.
  • Cant access capital required to execute growth
    strategy

6
Overall Evaluation of Overstocks Business
Strategy
  • Currently characterized by rapid growth, but no
    profits
  • Competition is high, so it will be difficult to
    establish a sustainable competitive advantage
  • Are they selling products to cheaply?
  • or
  • Are they investing in developing a first-mover
    advantage that will generate sustainable
    competitive advantage?

7
Key Takeaways
  • Do not assume that rapid sales growth reflects a
    viable business strategy. It is easy to grow
    when you are selling something for less than it
    costs.
  • Good ideas are easily imitated in a competitive
    industry
  • Economies of scale can create a first-mover
    advantage that may lead to sustainable
    competitive advantage

8
Overstock.comAccounting Analysis
9
Critical Accounting Policies
  • Revenue Recognition
  • Major switch from commission basis to gross basis
    for fulfillment partner revenue on July 1, 2003
  • Reserve for Returns
  • Allowance for Doubtful Accounts
  • Allowance for Obsolete and Damaged Inventory
  • Accounting for Income Taxes
  • Valuation of Long-Lived and Intangible Assets and
    Goodwill

10
GAAP Basis vs. Gross Basis Sales (see Gross to
GAAP reconciliation at the top of page 32 of Form
10-K)
11
Sales Growth
  • Growth rate in GAAP basis sales 238.9/91.8
    160
  • Growth rate in gross basis sales 278.8/142.8
    95

12
Source Nissim and Penman (2001)
13
GAAP Basis vs. Gross Basis Gross Profit
14
Gross Profit Growth
  • Growth rate in GAAP basis gross profit
    25.3/18.3 39
  • Growth rate in gross basis gross profit
    25.3/18.3 39

15
GAAP Basis vs. Gross Basis Common Size Income
Statements
16
Accounting Performance vs. Economic Performance
  • Overstock.com is investing significant amounts
    to fuel sales growth, customer loyalty and brand
    awareness. Most of these amounts must be
    immediately expensed for accounting purposes
  • Sales and marketing expenses
  • General and administrative expenses
  • Loss-leading margins on BMV merchandise

17
Key Takeaways
  • Subjective accounting choices can produce
    significant distortions to sales growth rates and
    profit margins. Make sure you are aware of such
    distortions before interpreting the information
    in the financial statements
  • GAAP requires the immediate expensing of many
    expenditures that are potentially investments
    that could lead to future benefits. Thus, lack
    of profitability does not necessarily imply a
    flawed business model.

18
Overstock.comRatio Analysis
19
Trade-Off 1Internet versus Bricks and Mortar
Bricks and Mortar
Internet
20
Trade-Off 2Liquidation versus Regular Retail
Liquidation
Regular Retail
21
Trade-Off 3Direct versus Fulfillment Partner
Fulfillment Partner (Commission-Basis)
Fulfillment Partner (Gross-Basis we take returns)
Direct
Fulfillment Partner (Gross-Basis they take
returns)
22
Trade-Off 4Discount Retailer versus Department
Store
Department Store
Discount Retailer
23
Overall Evaluation of Trade-Off
May Department Stores
Ross Stores
Amazon.com
Overstock.com
24
Dupont AnalysisOverstock versus Amazon
25
Dupont AnalysisOverstock versus Ross Stores
26
Dupont AnalysisOverstock versus May Dept Stores
27
Margins and TurnoverOverstock.com
28
Margins and TurnoverAmazon.com
29
Margins and TurnoverRoss Stores
30
Margins and TurnoverMay Department Stores
31
Key Insights from Analysis
  • Overstocks turnover looks a little slow
  • High balance of cash and marketable securities
    slows down aggregate turnover ratios
  • Aggressive use of fulfillment partners combined
    with gross-basis accounting for sales revenue
    should lead to higher turns than Amazon.com
  • Overstocks margins are currently way too low
  • Margins lag way behind competitors
  • Partly due to accounting distortions resulting
    from immediate expensing of SGA in a rapidly
    growing company
  • For long-term viability, gross margin needs to be
    in mid/high teens and operating expenses need to
    be in low/mid teens

32
Overstock.comForecasting Analysis(Using Q3
2005 see spreadsheet for details)
33
Forecasting Overview
  • Illustrates systematic framework for generating
    financial statement forecasts
  • eVal will walk you though this framework moving
    forward
  • Starting point is historical financial statements
  • Sales growth, margins, turnover ratios, leverage
  • Use insights generated from your analysis of the
    past to modify forecasting assumptions
  • Business analysis
  • Accounting analysis
  • Financial analysis

34
Framework for Business Analysis and Valuation
35
The Forecasting Process
Forecast Sales
Forecast Operating Margins
Forecast Turnover
Operating Expenses
Operating Assets and Liabilities
Forecast Leverage
Interest Expense
Tax Expense
Balance Sheet
Income Statement
Statement of Cash Flows
36
Sales Growth
  • Sales growth rate for
  • Q3 2004 79
  • Q4 2004 80
  • Q1 2005 102
  • Q2 2005 72
  • Guidance in 9/16/2005 press release
  • Investors should note that our restricted
    ability to post fresh inventory slowed sales
    sharply, a caesura from which we are now
    rebounding. In addition, the upgrade also caused
    inefficiencies that, when combined with our
    extended dollar shipping promotion, has put
    downward pressure on gross margins this quarter.
    However, my goal of growing 60 to 100 for the
    year at break even GAAP, /- 1, stands."

37
Margins Turnover
  • Gross margin lower based on guidance from 9/16/05
    press release
  • Technology expense higher due to information in
    press release
  • GA expense higher due to information in press
    release
  • Inventory/Sales up due to information in press
    release
  • PPE/Sales up due to tech upgrade
  • Goodwill up 25 million for Ski West Acquisition
    (see press releases 6/24/05 and 7/1/05)
  • Accounts Payable/Sales down due to information in
    press release

38
Leverage and the Balance Sheet Plug
  • No indication that OSTK issued/repurchased any
    common equity during Q3 05
  • No indication OSTK issued/retired any debt during
    Q3 05
  • I assume that OSTK funds cash shortfall for the
    quarter by selling marketable securities

39
Overstock.com
40
WR Hambrecht Valuation Method
41
Analyst Valuation Method
  • Analyst report uses comparable enterprise value
    to revenue multiples with discount retailing
    peers and internet bellwethers as comparisons
  • Argues that OSTK deserves a premium because of
    superior top-line growth prospects
  • Note that enterprise value equals market value of
    equity plus book value of debt less cash and
    short-term investments

42
Problems with Analyst Valuation Method
  • Implicitly assumes
  • OSTK can generate similar margins to comparison
    companies
  • OSTKs top-line sales growth will translate into
    bottom-line EPS growth, but OSTK is currently
    generating losses on its sales. In the long run,
    OSTK must generate ROE gt r for growth to generate
    value

43
Gross and Net Margin Comparison for 2003 (data
from eVal)
Gross Margin Net Margin
Overstock 11.7 -4.9
Ross Stores 27.5 5.8
Amazon 25.3 3.1
eBay 85.3 20.5
44
Default eVal Valuation
  • Default valuation is less than -4,000/share!
  • Default valuation extrapolates Overstocks
    artificially high 2003 sales growth rate of 160
    for 10 years into future
  • Default valuation extrapolates Overstocks 2003
    ROE of around 25 for the infinite future
  • Default valuation model assumes that Overstock
    will continue to lose money forever, but that
    investors will keep pumping new money into the
    business to cover these losses! (see cash flow
    analysis)
  • In reality, company will either turn to
    profitability in the not too distant future or go
    out of business

45
eVal Assumptions for 30 Valuation
  • Valuation Parameters
  • Valuation date 03/10/2004
  • Cost of equity capital10
  • Forecasting Assumptions
  • forecast horizon 10 years
  • Trend sales growth rate from 90 to 5
  • Trend COGS/Sales from 88 to 86.3
  • Trend SGA/Sales from 15 to 10
  • Trend Depreciation Rate down to 25
  • Set Interest Rate to 8 (cost of debt)
  • Trend Non-operating Income/Sales to 0
  • Set tax rate to 36 for terminal year (leave at 0
    for all prior years)
  • Trend Operating Cash/Sales to 3
  • Valuation31.76

46
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47
Plausible Valuation Assumptions
  • Valuation parameters
  • Valuation date 03/10/2004
  • Cost of equity capital 10
  • Forecasting Assumptions
  • horizon to 5 years
  • Trend sales growth rate from 90 to 5
  • Trend COGS/Sales from 88 to 86.3
  • Trend SGA/Sales from 15 to 10
  • Trend Depreciation Rate down to 25
  • Set Interest Rate to 8 (cost of debt)
  • Trend Non-operating Income/Sales to 0
  • Set tax rate to 36 for terminal year
  • Trend Operating Cash/Sales to 3
  • Valuation9.64

48
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49
Key Takeaways
  • Naïve use of comparable valuation multiples can
    be used to justify implausible valuations. It is
    important to understand the implicit assumptions
    in the use of comparable valuation multiples.
  • Growth and ROE interact to determine value
  • Terminal ROE must climb above cost of capital for
    business to be viable
  • OSTK operates in a highly competitive
    environment, so terminal ROE is unlikely to be
    more than 15
  • Given a terminal ROE of 15, the horizon over
    which OSTK can continue to grow at abnormally
    high rates is the key determinant of value
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