The tempting numbers behind Overstock

By Arne Alsin

Recognizing multibagger opportunities is difficult for most investors. Even when the opportunity sits squarely in front of them, most investors fail to see it.

For instance, observers were bewildered when Bill Miller was aggressively buying shares of Amazon.com (AMZN, news, msgs) below $7 per share in 2001. These observers couldn't see the earnings leverage in the Amazon model because of an overwhelming cloud of negativity.

An opportunity of similar magnitude to buying Amazon below $7 in 2001 exists today for investors in Overstock.com (OSTK, news, msgs). Over the next eight to 10 years, it's reasonable to expect Overstock will reach $4 billion in annual sales. If the operating model matures as I anticipate, the earnings and free cash flow will justify a business value of at least $4 billion, or more than nine times today's market value.

Increased share of market

While that may seem outrageous to some, there's a good chance that I'm too conservative. My sales-growth expectations, at 17% annually, are probably too low. Sales may be closer to $5 billion to $6 billion in eight to 10 years as Overstock continues to take share in the excess-inventory market, which is currently a $60 billion addressable market. Inefficient distribution of excess inventory is an expensive "headache" for brand-name manufacturers.

Overstock cures that headache.

Excess inventory levels are notoriously irregular and difficult for manufacturers to manage. They have to deal with unpredictable change in both the nominal level and across product categories. Using a single distribution partner, like Overstock, requires no capital outlay by manufacturers and results in fast conversion of excess inventory to cash.

Another reason my calculations may be too conservative is that the advantages of Overstock's business model may eventually command a premium valuation, perhaps 1.5 times sales. This implies a business value that is about 15 times the current value within this eight- to 10-year time period.

A model like Amazon is subject to assault based on price. For example, Buy.com is advertising books at 10% below the Amazon price. Overstock's model doesn't have the same vulnerability:

The online space that Overstock competes in is a winner-take-all category. As with eBay (EBAY, news, msgs), in the online auction space, there's a self-reinforcing dynamic at work here. Buyers naturally migrate to the inventory liquidation site that has the most product, and sellers want to sell on the site that has the most buyers. It's a mistake to underestimate the importance of this dynamic -- or its potential long-term value.

The 'magic' of organic growth

Look at the analyst reports in the early years of every great organic growth story, and you'll see that analysts miss this critical variable each and every time. That is, they underestimate earnings leverage. Organic growth begets powerful earnings leverage because it's exponentially cheaper to grow organically than to grow via acquisition.

It's irrefutable that Overstock has generated significant organic growth. The company's 2002 sales were $92 million, and sales this year will exceed 10 times that, or over $920 million. While I estimate that the Overstock model will eventually mature at a free cash flow margin of 3.5% of sales, it may be materially higher.

When Home Depot (HD, news, msgs) was generating 3.5% to 4% net margins several years ago, analysts (including me) failed to identify the earnings leverage in the model that resulted in 7% margins. It's quite impressive that Dell (DELL, news, msgs) can sell a low-margin commodity product and generate well over 6% net margins (up from less than 2% in the early years). If I had been given Dell's operating metrics in the early days, my guess is that I would have estimated, at the very most, an ultimate net margin level of only 3% or so.

The most powerful earnings leverage is found in operating models, like those discussed above, where there is a combination of both organic growth and category dominance. Because Overstock has both organic growth and dominates a winner-take-all online category, it's reasonably likely that I have underestimated its long-term profitability.

Because of the way earnings leverage works, the transition from losing 2 to 3 cents to earning 3 cents or more per dollar of revenue requires nothing heroic for Overstock. At $1 billion in sales, the company generates $150 million in gross profit dollars. (I consider a 15% gross margin a conservative assumption.) At $2 billion it generates $300 million, and at $4 billion it generates $600 million. Costs such as marketing, technology and G&A (general and administrative) grow in nominal terms, but not as a percentage of sales.

Think of technology and G&A as the cost of "headquarters." Much of that cost is front-end loaded. While headquarters will cost more at $2 billion in sales than it does at $1 billion in sales, it will not cost anywhere near twice as much.

High-risk phase is over

That marketing expense will decline as a percent of sales is obvious. But building a No. 1 brand -- a top-five retail online destination -- is expensive. According to industry sources, Overstock has gone from zero unprompted name recognition a few years ago to 4% about 30 months ago, to 29% today (for purposes of comparison, Amazon is at 44%). Prompted name recognition is also impressive, at 70%. With the brand-building phase nearly complete, marketing dollars naturally decline as a percentage of revenue.

The high-risk phase in the Overstock evolution is over -- that's the early phase in which Overstock emerged as the clear leader from a pack of competitors such as Ubid, eCost, Buy.com, Mercata and SmartBargains.

There will be dozens of reasons over the next eight to 10 years for Overstock investors to short-circuit this multibagger opportunity. While this model is exceedingly well positioned, it will not grow in a linear fashion. Like most great organic growth stories, this one will grow in fits and starts, marked by periods of brilliance as well as error.

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