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An Analysis Of Overstock.com (OSTK)
By: Geoff Gannon
Why is a value investor writing about an unprofitable internet company? Because
value investing is about finding dollars that trade for fifty cents; with a
market cap of less than 75% of sales, Overstock.com (OSTK) looks like it may be
exactly that.
But isn’t it too risky?
The greatest risk in any investment is the risk of overpaying. So, the real
question is: what is Overstock worth? I think it’s worth at least $1.5 billion.
With Overstock’s market cap currently sitting around $500 million, my valuation
certainly looks far fetched. But, there’s only one way to know for sure. Let’s
take apart my argument piece by piece, and see if any of my assumptions are
unreasonable.
First Assumption: Over the next five years, Overstock will neither generate
truly free cash flow nor consume cash. In other words, its free cash flow margin
will average 0%. Cash generation in some years will exactly offset cash
consumption in other years. Obviously, this assumption is unreasonable, because
there is almost no chance the cash flows will exactly offset.
That’s not a problem if it turns out Overstock does generate some free cash flow
over the next five years. In that case, my assumption simply errs on the side of
caution. If, however, it turns out Overstock actually consumes cash over the
next five years, there is a problem – possibly a very big problem. So, which
scenario is more likely?
Overstock’s revenues are growing quickly. Gross margins look solid at 13.3% in
2004 and 14.9% over the last twelve months. Overstock’s unprofitability is the
result of its selling, general, and administrative expenses (SG&A) which have
been growing exponentially. Will these expenses continue to grow? Yes, but not
as fast as revenues. Over the last twelve months, Overstock’s spending on cap ex
has been 5.6% of sales. That number is an aberration. In the long run, spending
on cap ex should not exceed 3% of sales. Considering the business Overstock is
in and the expected sales growth, the company will, more likely than not,
generate some free cash flow over the next five years. Therefore, the assumption
that Overstock will be cash flow neutral over the next five years is not overly
optimistic.
Second Assumption: Over the next five years, Overstock’s sales will grow by 15%
annually. Is this an unreasonable assumption? Again, I don’t think it is. Very
few industries are expected to grow as fast as eCommerce. Overstock’s revenue
growth in 2003 and 2004 was over 100%. In the past year, that growth has slowed.
However, it is still closer to 50% than it is to 15%. Overstock isn’t in a
cyclical business. So, there is no reason to believe current sales are
abnormally high.
Also, all that spending on advertising is increasing consumers’ awareness of
Overstock. A review of Overstock’s traffic data shows it has not only been
gaining more visitors; it has also been climbing the ranks of the most popular
web sites. While it is a long, long way from the Amazons, Yahoos, and eBays of
the world (and will never reach those heights) Overstock is becoming a well
known internet destination. This fact was most clearly evident in the weeks
leading up to Christmas. Shoppers who visited Overstock during the holiday
season obviously know it exists, and may very well return at some other point in
the year. Analysts are predicting very high growth rates for Overstock; however,
they are also recommending you sell the stock. I don’t put any weight in their
estimates. But, for the other reasons given, I believe the assumption that
Overstock will grow sales at 15% a year for the next five years is not
unreasonable.
Third Assumption: Six to ten years from today, Overstock will have a free cash
flow margin of 3%. Ten years from today, Overstock’s free cash flow margin will
rise to 4% and remain at that level. Now, of all the assumptions I’ve made, this
one is the most questionable. Sure, Amazon has that kind of free cash flow
margin, but Overstock isn’t Amazon, and it never will be Amazon. Overstock’s
gross margins are less than Amazon’s. In fact, Overstock’s gross margins are
less than Wal – Mart’s. However, Overstock’s fixed costs will eat up a much
smaller portion of its sales than is the case over at Wal - Mart.
If you compare Overstock to other online retailers, you will see that if
Overstock does experience strong sales growth, a 3% free cash flow margin six
years from now is not unreasonable. I assumed Overstock’s sustainable free cash
flow margin will be 4%. There’s a case to be made that 4% is too high. I won’t
make that case, because I don’t believe in it. Remember, that 4% number comes
ten years out. That gives Overstock plenty of time to grow sales and thus reduce
SG&A as a percentage of sales.
Fourth Assumption: Six to ten years from today, Overstock will be growing sales
by 12% a year; eleven to fifteen years from today, Overstock will be growing
sales by 8% a year; thereafter, Overstock will grow sales by 4% a year. Let’s
see what this really means. According to these assumptions, Overstock’s sales
will be as follows:
Today: $707 million
2011: $1.59 billion
2016: $2.71 billion
2021: $3.83 billion
2026: $4.66 billion
2031: $5.67 billion
2036: $6.90 billion
Seven billion dollars is not an unreasonable target – if you have thirty years
to achieve it. To put that figure in perspective, Amazon.com currently has sales
of about $8 billion. So, even after thirty years, these assumptions don’t lead
to Overstock reaching the same size as today’s Amazon. Don’t forget these
numbers assume some inflation. For instance, if inflation averages 3% a year
over the next thirty years, Overstock’s projected $6.90 billion in sales only
translates to $2.84 billion in today’s dollars. So, these assumptions only lead
to a fourfold increase in Overstock’s real sales over a period of thirty years.
I think that’s pretty reasonable.
If you take these four assumptions together, you get a value of $1.5 billion for
Overstock. Today, Mr. Market is offering it for $500 million – that’s why I’m
writing about an unprofitable internet company.
About the Author:
Geoff Gannon writes a daily value investing blog and produces a twice weekly
(half hour) value investing podcast at Gannon On Investing |
