Why is a value investor writing about a company that isn't making money on the internet? Because value investing is about finding dollars that trade for fifty cents, it looks like Overstock.com (OSTK), which has a market cap of less than 75% of its sales, may be just that.
But isn't that too dangerous?
The biggest risk of any investment is that you will pay too much for it. The real question is, then, how much is Overstock worth? I think it is at least worth $1.5 billion. With Overstock's market value at around $500 million right now, my estimate seems very high. But there is only one sure way to find out. Let's take my argument apart piece by piece and see if any of the things I'm assuming are wrong.
First assumption: In the next five years, Overstock will neither make money nor spend money. In other words, the average margin on its free cash flow will be 0%. In some years, cash will be made exactly equal to cash spent in other years. This assumption is obviously wrong, since there is almost no chance that the cash flows will be exactly the same.
That won't be a problem if Overstock is able to make some money without spending any of its own cash over the next five years. If that's the case, my guess is just on the safe side. But if it turns out that Overstock actually spends money over the next five years, there is a problem, and it could be a very big one. So, which of the two options is more likely?
The amount of money Overstock makes is growing quickly. At 13.3 percent in 2004 and 14.9 percent over the last year, gross margins look good. Overstock isn't making money because its selling, general, and administrative costs (SG&A) have been growing at a very fast rate. Will these costs keep on going up? Yes, but not as quickly as income. Overstock has spent 5.6% of its sales on capital expenditures over the past year. That number is out of place. Long term, the amount spent on capital expenditures shouldn't be more than 3% of sales. Taking into account the type of business Overstock is in and the expected growth in sales, it is likely that the company will have some free cash flow in the next five years. So, it's not too optimistic to think that Overstock will have no cash flow problems in the next five years.
Second Assumption: Overstock's sales will grow by 15% a year for the next five years. Is this a reasonable thing to think? I'll say it again: I don't think so. eCommerce is expected to grow much faster than almost any other business. In 2003 and 2004, Overstock's sales grew by more than 100%. This growth has slowed over the past year. But it's still closer to 50% than 15%. Overstock isn't in a business that goes up and down. So, there's no reason to think that sales right now are unusually high.
Also, all the money Overstock spends on advertising makes people more aware of the company. When you look at Overstock's traffic data, you can see that it has been getting more visitors and moving up the list of the most popular websites. Even though it is a long way from Amazon, Yahoo, and eBay, Overstock is becoming a well-known place to go online. It will never reach those heights, though. The weeks before Christmas were the clearest time to see this. People who shopped at Overstock during the holidays know it's there, and they may go back at some other time of the year. Analysts think that Overstock will grow very quickly, but they also say that you should sell the stock. I don't pay any attention to what they say. But for the other reasons given, I don't think it's crazy to think that Overstock's sales will grow by 15% a year for the next five years.
Third Assumption: Overstock will have a 3 percent free cash flow margin six to ten years from now. Overstock's free cash flow margin will go up to 4 percent in ten years and stay there. Now, this is the most questionable assumption I've made so far. Amazon does have a free cash flow margin like that, but Overstock isn't Amazon and never will be. Amazon has higher gross margins than Overstock. In fact, Overstock has a lower gross margin than Wal-Mart. But Overstock's fixed costs will eat up a much smaller percentage of its sales than Wal-do. Mart's
If you look at how Overstock compares to other online stores, you'll see that a 3 percent free cash flow margin in six years is not too much to ask for if Overstock has strong sales growth. I thought that Overstock's long-term free cash flow margin would be 4%. It could be argued that 4 percent is too much. I won't argue that, because I don't think it's true. Don't forget that 4 percent number is for ten years from now. That gives Overstock a lot of time to increase sales and lower SG&A as a share of sales.
Fourth Assumption: In the next six to ten years, Overstock's sales will grow by 12 percent a year. In the next eleven to fifteen years, Overstock's sales will grow by 8 percent a year. After that, Overstock's sales will grow by 4 percent a year. Let's figure out what this means. Based on these assumptions, this is what Overstock's sales will be:
Today: $707,000,000
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 impossible goal to reach, as long as you give yourself thirty years to do it. To give you an idea of how big that number is, Amazon.com makes about $8 billion in sales every year. So, even if these assumptions are true, it won't take thirty years for Overstock to get as big as Amazon is now. Don't forget that these numbers take inflation into account. For example, if inflation stays at an average of 3% per year for the next 30 years, Overstock's expected sales of $6.90 billion will only be worth $2.84 billion in today's money. So, based on these assumptions, Overstock's real sales only go up by four times in thirty years. I think that's a good answer.
Using these four assumptions, you can figure out that Overstock is worth $1.5 billion. Today, Mr. Market is selling it for $500 million, which is why I'm writing about a company that isn't making any money on the internet.
