Thursday, May 03, 2007

Is Patrick Byrne, Overstock.com CEO, making false, misleading, and/or deceptive statements about the company’s financial issues?

During my days at Crazy Eddie, I hardly ever encountered tough detailed questioning by the Wall Street analysts covering its stock. Too often, the Wall Street analysts hoped to get chummy with Eddie Antar and me, to gain investment banking business, our attendance at their sponsored forums, or to gain coveted direct access to us. We believed that we knew how to play with the wants and needs of Wall Street analysts to corrode their professional skepticism.

As criminals, we feared skepticism and cynicism from our external auditors, Wall Street analysts, journalists, and investors. We found that most people did not know how to ask good questions, whom to ask such questions to, and how to ask good follow up questions to our deceitful answers.


In my previous post on my blog entitled “Questions the Securities and Exchange Commission may ask Patrick Byrne (CEO of Overstock.com) in its investigation of (not “on”) Overstock.com” I suggested certain questions that the Securities and Exchange Commission may want to consider asking Mr. Byrne about inventory and gross margin disclosures by Overstock.com.


Afterwards, Tracy Coenen, Certified Public Accountant and Certified Fraud Examiner, had written a blog post entitled “Today’s earnings call for Overstock (OSTK)” and examined certain statements made by Patrick Byrne (CEO of Overstock.com) and Jason C. Lindsey (President of Overstock.com) at its recent earnings conference call for the 1st quarter ended March 31, 2007.

She wrote:

According to the
transcript of today’s earnings call, they said:

Jason C. Lindsey: “I am pleased with the quarter. I think we made a big improvement….”

Patrick M. Byrne: “I will echo that… I think that this is what we aimed for a year ago but I am not sure that either Jason or I believed we could actually get to this point but we are excited about these operating improvements.”

Improvements? Pleased??? Come on now. Their definition of “improving” certainly must be a lot different from mine. Why? The company is doing horribly.

  • Revenue for the quarter was down 11%
  • Operating losses for the quarter were $17.7 million
  • Operating losses were $3.5 million more than last year
  • Net losses for the quarter were $21.4 million
  • Net losses were $5.5 million more than last year

Who in their right mind believes that such numbers represent an improvement in the business???

Oh sure, the one bright spot is that gross margins improved. That’s what they’re hanging their hat on Or did they? Sam Antar raises some really good questions about Overstock’s third and fourth quarters of 2006, and in particular, questions about inventories and gross margins. (Note that none of the analysts asked any of the questions, and Overstock executives certainly didn’t offer up any answers voluntarily.)

In a later post on her blog, entitled "Is Overstock.com misrepresenting inventory?" Tracy Coenen examined Overstock.com's inventory disclosures.

She wrote in part:

At 12/31/05, Overstock reported $98.5 million of inventory, with a reserve of $5.2 million. The reserve was 5.3% of the total inventory.

At 12/31/06, Overstock reported $26.9 million of inventory, with a reserve of $6.6 million. The reserve was 24.5% of the total inventory.

So let’s get this straight… in terms of raw dollars, the obsolete (junk) inventory was greater at the end of 2006 than it was at the end of 2005. And as a percentage of total inventory, the obsolete (junk) inventory was over 4 times higher than 2005.

How is this inventory more attractive when you’re admiting that 1/4 of it is junk??? Or, was way more junk sitting around in 2005, but the company purposely did not reserve for it? (Which would, oddly enough, probably be a material misstatement in the financial statements.)


Recent Securities and Exchange Commission Form 8 – K filed by Overstock.com for the quarter ended March 31, 2007

On April 25, 2007, Overstock.com disclosed its first quarter ending March 31, 2007 financial results in a
form 8 – K, filed with the Securities and Exchange Commission. That same day Overstock.com conducted an earnings conference call with certain Wall Street analysts.

Among the disclosures included in the form 8 – K were:

  • Total revenue: $157.9 million, down 11% from 2006
  • Gross profits: $25.3 million, up 7% from 2006
  • Gross margin: 16.0% up from 13.3% in 2006
  • Sales and marketing expense: $11.3 million, down 11% from 2006
  • Contribution (gross profit less marketing expense): $14.0 million, up 26% from $11.1 million in 2006
  • Contribution margin: 8.9% up from 6.2% in 2006
  • General and administrative expense: $10.7 million, down 10% from 2006
  • Operating loss before restructuring charge (non-GAAP): $11.6 million, an 18% improvement from 2006
  • Operating loss: $17.7 million versus $14.2 million in 2006
  • Net loss: $21.4 million or $0.91 loss per share

Note: Bold print and italics added

In the form 8 – K, Patrick Byrne (CEO of Overstock.com) purported:

Our business is dramatically improving. Gross and contribution margins are expanding, and contribution dollars are up sharply. G&A expenses are contracting. That said, the corporate relocation to the warehouse remains uncertain: if we go forward with it, we will incur additional restructuring charges. I leave each to make her own determination regarding our results, look forward to our call, and as always, remain,

Your humble servant,

Patrick M. Byrne

Note: Bold print and italics added


Background

For the 4th quarter ended December 31, 2006, Overstock.com suffered negative gross margins on direct revenues. In addition, sales declined. They purported that they were getting rid of slow moving inventory as net inventory levels dropped from $68.8 million from the end of the 3rd quarter to $20.3 million at the end of the 4th quarter. During the 4th quarter, company added significant relative amounts to reserves for Obsolete and Damaged Inventory from about 6.1% of gross inventory totals at the end of the 3rd quarter to about 24.5% of gross inventory at the end of the 4th quarter. The company suffered a net loss of about $45.6 million in its last quarter of the fiscal year..

The company purported to explain its inventory and gross margins in the 10 – K for the fiscal year ended December 31, 2006:

I quote the following disclosure from Overstock.com’s 10 – K, for the fiscal year ended December 31, 2006, relating to gross margins:

Commentary—Gross Margins. We consciously and aggressively discounted older inventory during the fourth quarter, and as a result, our direct gross margins were negatively impacted. However, we did this to significantly clean and reduce our inventory in an effort to reduce the overall SKU (stock keeping unit) count on our website and to refine our product selection to categories that turn faster and have higher profitability. We believe that we can run our direct business with less inventory than we have had in the past, while filling in product selection using fulfillment partners, rather than acquiring the inventory directly. As a result of these efforts, we believe that we should see a significant improvement in direct and overall gross margins beginning in the first quarter of 2007. With reduced inventory levels, we now have excess warehouse capacity, and we are therefore making efforts to reduce warehouse space. We believe that we will see additional improvement to direct gross margins if and when we are able to successfully do this.

Note: Bold print and italics added


Comments by Patrick Byrne at the Overstock.com earnings conference call about inventories and gross margins

During the 1st quarter earnings conference call, Patrick Byrne (CEO of Overstock.com) attempted to reflect on his purported actions during the previous fiscal year. However, no analyst attending the earnings conference call asked him any follow up questions. Mr. Byrne said:

We had our game plan. Really, we had our game plan as of Q1 last year of what was going to have to happen.

We knew things were going to get really ugly and the company was going to have take medicine but that we could come out of it a far better company, and that medicine was going to be in the form of some expenses, it was going to be in the form of dumping a bunch of inventory as we figured out really how to take our inventory management to the next level -- all kinds of things. We knew it was going to get ugly. Maybe not as ugly as it got but we thought we would come out in the first quarter smelling like a rose operationally and this is exactly what we -- what I at least thought was going to happen in the first quarter.

Note: Bold print and italics added


Certain questions that the Wall Street analysts attending the conference call should have asked Patrick Byrne

Mr. Byrne, if you:

  • had your “game plan as of Q1 last year of what was going to have to happen” and
  • you “knew things were going to get really ugly and the company was going to have take medicine” and
  • that medicine was going to be in the form of some expenses” and
  • it was going to be in the form of dumping a bunch of inventory

Why did Overstock.com wait until the 4th quarter of the fiscal year ended December 31, 2006 to take relatively high reserves against its inventory?

See the table below:

Selected Inventory Information from Overstock.com SEC filings

Quarter Ended 12/31/05

Quarter Ended 03/31/06

Quarter Ended 06/30/06

Quarter Ended 09/30/06

Quarter Ended 12/31/06

Gross Inventory (in millions of dollars)

98.5

84.7

78.2

73.3

26.9

Reserve for Obsolete and Damaged Inventory (in millions of dollars)

5.2

3.3

3.4

4.5

6.6

Net Inventory (in millions of dollars)

93.3

81.4

74.8

68.8

20.3

Percentage of Reserve for Obsolete and Damaged Inventory to Gross Inventory

5.3%

3.9%

4.3%

6.1%

24.5%



More Comments by Patrick Byrne and Jason C. Lindsey in Overstock.com recent 8 –K and at the Overstock.com earnings conference call about inventories and gross margins

During the earnings conference call, Jason C. Lindsey would purport:

….another dynamic that is going on is as we liquidated all of our slow-moving inventory and things that did not meet our metrics last year, we really sold everything and got our inventory extremely fresh.

Note: Bold print and Italics added

Later, Jason C. Lindsey said the following:

….so we do still have several million dollars worth of stuff that we call our excess inventory from last year that we didn’t liquidate that we are going to be liquidating now and even into the beginning of the third quarter. Although we reserved against that and do feel like we have an adequate reserve and that we will be forced to -- and we will release that reserve some as we sell that stuff. I am just not sure exactly the clearing price of all that.

Note: Bold print and italics added

Patrick Byrne would elaborate further:

But the one set of things he didn’t do was the millions of dollars of that furniture, wrought-iron furniture, you can’t sell it at Christmas. But we do have -- a big chunk of our inventory is still that and when that disappears over the next two months, three months, that is a significant chunk of our inventory and Jason has taken a very healthy reserve against all of that inventory.

Note: Bold print and italics added

Jason C. Lindsey would later purport:

What we are shooting for around here are margins of somewhere around 20%....

I think they will probably go up some, but again you do have two things going on there. One, we have some inventory that is kind of left over that was spring inventory that we are trying to liquidate now, and you are going to replace that with better inventory, so those two dynamics are going against each other, although the $16 million number is a net number against the reserve against that inventory, so I do think it will come up. We are retailer so we are going to build inventories in the third quarter and then sell it in the fourth….

Note: Bold print and italics added



Additional questions the Wall Street analysts should have asked Patrick Byrne and Jason C. Lindsey about inventories and gross margins

Please discuss the impact of Overstock.com's 4th quarter fiscal year 2006 inventory reserves on gross margins for the 1st quarter ended March 31, 2007 and future quarters.

If that entire inventory on hand at the end of the 4th quarter of the fiscal year ended December 31, 2006, was sold at its original cost of $26,859,000 in later quarters, would you agree that Overstock.com would recognize gross margins of $6,585,000 in future accounting periods?

Under such a circumstance, would gross margins recognized on that inventory (if sold at original cost) be about 24.5% (which is higher than historical gross margins for Overstock.com).

Can you discuss in detail, how the use of inventory reserves contributes to Overstock.com’s purported improvement in its financial condition?

How does the inventory reserves taken in the 4th quarter impact the purported improvements in gross margins during the first quarter of fiscal year 2007 and future quarters?

Can you describe the specific financial impact of releasing those reserves?

How does that “very healthy reserve against all of that inventory” help Overstock.com’s reported gross margins in future accounting periods?



Recent Comments by Patrick Byrne and Jason C. Lindsey in Overstock.com recent 8 –K and at the Overstock.com earnings conference call about guidance

During the earnings conference call, Jason C. Lindsey said:

Well, regarding guidance, this is kind of a slippery slope and our official stance has always been we do not offer guidance, so my comment I guess first is I don’t want to go into the line items in the model and tell you what I think and don’t think about the different line items.

However, he goes on to say:

I can say, just like I said last quarter, Dave told me 10 minutes before the call that the consensus estimate was somewhere around $60 million, and I said on the call I was quite comfortable with that. I was comfortable with that. I am comfortable with it. I am still comfortable with it. In fact, I am more comfortable with it now than I was before, but I still think it is a good number.

Note: Bold print and italics added

Earlier, in the year Patrick Byrne was interviewed by Greg Sandoval for an entitled “Newsmaker: CEO in the Hot Seat” published by c/net news.com on March 6, 2006. I quote the following:

What are Overstock's problems right now, and when will the company be profitable?

Byrne:

I don't know. We have a plan this year that we should cross the billion-dollar mark. Put it this way: Amazon, at our stage, was losing $1.2 million a year in operations. It made up a phony accounting standard--pro forma. And when it reached pro forma breakeven, Wall Street set off fireworks.

When it reached EBITDA (earnings before interest, tax, depreciation and amortization) breakeven, Wall Street wanted to declare it a national holiday. I've never used pro forma in my life. We've had some GAAP (generally accepted accounting principles) profitable quarters, plenty of operating profit and EBITDA profitable quarters. This year, with a little luck, we should be an EBITDA-profitable year, so I'm kind of comfortable with that.

Note: Bold print and italics added



Questions the Wall Street analysts should have asked Jason C. Lindsey and Patrick Byrne about earning guidance

Mr. Lindsey purports being “comfortable” with the “consensus estimate” of “somewhere around $60 million” for operating losses for fiscal year 2007 a code word for giving earnings guidance.

Question: Mr. Lindsey, didn’t you say the following comments during the 4th quarter earning conference call?

I have seen what the consistent estimate, or the analysts’ consensus for us for 2007 is, and I know many of the analysts have models and it’s a difficult spot that they are in because they are trying to update their models without guidance. I just want to make a couple of comments, because maybe it will help the Q&A.

You have us for the year at a 5% growth rate and 8.5% of sales on marketing. When I look at that, and you have operating income of $60 million, more than a $60 million loss, although in total I think your numbers seem reasonable and I am okay with all of them, I do think that we get there a slightly different way.

Note: Bold print and italics added

Mr. Byrne when you said “This year, with a little luck, we should be an EBITDA-profitable year, so I'm kind of comfortable with that” were you giving earnings guidance?

You said in your interview “Put it this way: Amazon, at our stage, was losing $1.2 million a year in operations. It made up a phony accounting standard--pro forma…. I've never used pro forma in my life.”

However, during the 1st quarter earnings conference call, you said:

Next slide, slide 4. I am going to spend a moment on this to remind folks that there is the GAAP gross margin and then what we call “Juice”. The difference is basically the fixed warehouse cost and a little bit of coupons we -- internally we have already accounted for that differently. Coupons and shipping promotions we account as a marketing cost but under GAAP it is a reduction of revenue.

Note: Bold print and italics added

Mr. Byrne, didn’t you use “pro forma” accounting during this earnings conference call?

In Overstock.com’s recent 8 – K for the 1st quarter of fiscal year 2007, there was the following disclosure:

Operating loss before restructuring charge (non-GAAP): $11.6 million, an 18% improvement from 2006

However, Mr. Byrne you previously said, “It [Amazon.com] made up a phony accounting standard--pro forma…. I've never used pro forma in my life.”

Mr. Byrne, do you use pro-forma accounting when it suits your purpose on presenting the company in the best light?



Certain comments by the Wall Street analysts attending the conference call

Rather than ask detailed critical questions to Overstock.com’s management, the Wall Street analysts threw softball questions and praised the latest quarter.

For example, Aaron Kessler from Piper Jaffray would comment:

Good quarter, good to see the improvement on the margin side.

Mr. Kessler asked no detailed questions about the impact of previous reserves on current gross margins reported for the 1st quarter by Overstock.com. He did not ask questions about valuations of inventory in previous accounting periods.

Instead, he would comment and ask:

Great, and then a couple of other questions; where do you expect gross margins to go in the direct side over the next few quarters?

And Patrick Byrne and Jason C. Lindsey would respond:

Patrick M. Byrne:
Jason, what do you want to say about core margins?

Jason C. Lindsey:
I am pleased with where they are at. Hopefully they can continue to sneak up but I do not anticipate anything, any huge stair steps from here.

Patrick M. Byrne:
I would not anticipate stair steps. I think that they float up but I think --

Jason C. Lindsey:
I hope they float up as well. I hope that they do. I think that they can.

Later, Mr. Lindsey elaborated further:

I think it should float up but I would not be surprised if it does not come up much for another quarter or two.

However, Jason C. Lindsey had said:

Well, regarding guidance, this is kind of a slippery slope and our official stance has always been we do not offer guidance, so my comment I guess first is I don’t want to go into the line items in the model and tell you what I think and don’t think about the different line items.

Note: Bold print and italics added



The Time Line according to Patrick Byrne

January 1 to March 31, 2006:

During the 1st quarter earnings conference call for fiscal year 2007, Patrick Byrne attempted to explain inventories and gross margins for the previous fiscal year.

He talked about purported decisions made during the first quarter of fiscal year 2006:

Really, we had our game plan as of Q1 last year of what was going to have to happen.

We knew things were going to get really ugly and the company was going to have take medicine but that we could come out of it a far better company, and that medicine was going to be in the form of some expenses, it was going to be in the form of dumping a bunch of inventory as we figured.


Note: Bold print and italics added.

See table below:

Selected Inventory Information from Overstock.com SEC filings

Quarter Ended 12/31/05

Quarter Ended 03/31/06

Gross Inventory (in millions of dollars)

98.5

84.7

Reserve for Obsolete and Damaged Inventory (in millions of dollars)

5.2

3.3

Net Inventory (in millions of dollars)

93.3

81.4

Percentage of Reserve for Obsolete and Damaged Inventory to Gross Inventory

5.3%

3.9%



However, the percentage of Reserve for Obsolete and Damaged Inventory to Gross Inventory declines from the previous quarter.


May 9, 2006:

After the first quarter 10 – Q was released, the SEC subpoenas financial information from Overstock.com as it began an investigation of the company.

According to Overstock.com’s recent 10 – K and other documents filed with the Securities and Exchange Commission, they subpoenaed:

….a broad range of documents, including, among other documents, all documents relating to our accounting policies, our targets, projections or estimates related to financial performance, our recent restatement of its financial statements, the filing of our complaint against Gradient Analytics, Inc., the development and implementation of certain new technology systems and disclosures of progress and problems with those systems, communications with and regarding investment analysts, communications regarding shareholders who did not receive our proxy statement in April 2006, communications with certain shareholders, and communications regarding short selling, naked short selling, purchases and sales of our stock, obtaining paper certificates, and stock loan or borrow of our shares.

Note: Bold print and italics added

Quarter ended June 30, 2006:

After the Securities and Exchange Commission starts its investigation of Overstock.com, the percentage of Reserve for Obsolete and Damaged Inventory to Gross Inventory begins to increase. However, the Percentage of Reserve for Obsolete and Damaged Inventory to Gross Inventory is below December 31, 2005 levels.

See table below:

Selected Inventory Information from Overstock.com SEC filings

Quarter Ended 12/31/05

Quarter Ended 03/31/06

Quarter Ended 06/30/06

Gross Inventory (in millions of dollars)

98.5

84.7

78.2

Reserve for Obsolete and Damaged Inventory (in millions of dollars)

5.2

3.3

3.4

Net Inventory (in millions of dollars)

93.3

81.4

74.8

Percentage of Reserve for Obsolete and Damaged Inventory to Gross Inventory

5.3%

3.9%

4.3%



Quarter ended September 30, 2006:

The percentage of Reserve for Obsolete and Damaged Inventory to Gross Inventory continues to increase after the SEC began its investigation of Overstock.com.

See table below:

Selected Inventory Information from Overstock.com SEC filings

Quarter Ended 12/31/05

Quarter Ended 03/31/06

Quarter Ended 06/30/06

Quarter Ended 09/30/06

Gross Inventory (in millions of dollars)

98.5

84.7

78.2

73.3

Reserve for Obsolete and Damaged Inventory (in millions of dollars)

5.2

3.3

3.4

4.5

Net Inventory (in millions of dollars)

93.3

81.4

74.8

68.8

Percentage of Reserve for Obsolete and Damaged Inventory to Gross Inventory

5.3%

3.9%

4.3%

6.1%



Quarter Ended December 31, 2006:

Overstock.com records a massive increase in the percentage of Reserve for Obsolete and Damaged Inventory to Gross Inventory.

During the 4th quarter earnings conference call, Jason C. Lindsey states:

All of the things we have talked about before as far as classifying all of our SKUs as either red and green and 80% of our -- excuse me, 20% of our inventory was doing 80% of our gross profits, or even more than that. We took all that to heart in the fourth quarter and although the fourth quarter results are very bad, and I admit they are very bad, they were bad on purpose. In other words, we used the fourth quarter to get rid of all the slow-moving inventory. I am quite pleased with the inventory balances we have now.

Note: Bold and italics added

See the table below:

Selected Inventory Information from Overstock.com SEC filings

Quarter Ended 12/31/05

Quarter Ended 03/31/06

Quarter Ended 06/30/06

Quarter Ended 09/30/06

Quarter Ended 12/31/06

Gross Inventory (in millions of dollars)

98.5

84.7

78.2

73.3

26.9

Reserve for Obsolete and Damaged Inventory (in millions of dollars)

5.2

3.3

3.4

4.5

6.6

Net Inventory (in millions of dollars)

93.3

81.4

74.8

68.8

20.3

Percentage of Reserve for Obsolete and Damaged Inventory to Gross Inventory

5.3%

3.9%

4.3%

6.1%

24.5%



Additional issues

It appears that the caliber of many Wall Street analysts has not changed much since my days at Crazy Eddie. They seem to be more interested in serving their own personal agendas and pleasing management rather than serving the interests of the readers of their financial reports.

Patrick Byrne said in Overstock.com's 8 – K for the 1st quarter of fiscal year 2007:

I leave each to make her own determination regarding our results....

Be careful about discussing Overstock.com’s results. You may get sued!

USA Today interviewed Patrick Byrne about executives “playing dumb” in an article published on March 16, 2005 and entitled “Ignorance isn't bliss for execs on trial.”

Chief executives who are mounting legal defenses should be wary of playing dumb, warns Patrick Byrne, CEO of Overstock.com. Such a posture could insult a jury, he says. Maybe that's their only choice, but "Ebbers would have been better to plea bargain to 15 years," rather than "tick jurors off ... with a provocative defense," Byrne says.

Perhaps, Mr. Byrne should follow his own advice.

The Securities and Exchange Commission of (sorry Patrick, not on) Overstock.com continues after they dropped the Gradient probe.

If charges are brought against Patrick Byrne by the Securities and Exchange Commission, he “should be wary of playing dumb.”

Written by:

Sam E. Antar (former Crazy Eddie CFO & convicted felon)

Additional blogs covering Overstock.com’s 1st quarter earnings for fiscal year 2007:

The Motley Fool: Dramatic Losses at Overstock, by Seth Jayson

Gary Weiss Blog: Is Overstock.com’s Quarterly Delusion ‘Materially Misleading’?

Other interesting reading about Overstock.com

Lee Distand's Professional Opinion: Sam E. Antar is Mad as Hell about Overstock.com

Jeff Matthews is not making it up blog: The Patrick Awards Part 1

O-Smear blog: Overstock FINALLLY Eats Its Own cooking

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