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.
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