Thursday, August 23, 2007

Did Overstock.com CEO Patrick Byrne cook the company's numbers and mislead investors? (Part 3 - The end game)

Blog series: Did Overstock.com CEO Patrick Byrne cook the company's numbers and mislead investors?

In the first two parts, I detailed Overstock.com and its management's inconsistent, conflicting, contradictory, and deceitful disclosures in its financial reporting.

In part 1, I detailed how Patrick Byrne backtracked and used in his own words, a "a phony accounting standard--pro forma," the reduction of inventory reserves, and the reversal of previously booked nonrecurring expenses to hype up Overstock.com financial performance for the second quarter of fiscal year 2007. Without, the use of that "phony accounting standard--pro forma," Overstock.com's hyped up turn around would have all but disappeared. In addition, I detailed how the reduction in inventory reserves in the second quarter of fiscal year 2007, wiped away Overstock.com's entire improvement in operating income.

In part 2 of this series, I detailed the possible manipulation of earnings by Overstock.com using a technique, known as "managing earnings," that involves manipulating inventory reserves. I detailed how statements by Overstock.com about inventory and reserves are inconsistent and contradictory and as a result point to the possible manipulation of earnings.

In Part 3, we get to the end game. I discuss why Overstock.com's two inconsistent, conflicting, and contradictory stories cannot coexist. I ask Overstock.com, Patrick Byrne, the Board of Directors, and Clay Corbus and Joseph J. Tabacco Jr. (Audit Committee members) to respond to the questions and issues I have raised.

Before I get to the end game, let's review certain facts from my previous blog item

In the first quarter of fiscal year 2006, Patrick Byrne had a "game plan." He "knew that things were going to get very ugly" at Overstock.com. He knew that "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." Patrick Byrne waited almost an entire year to tell investors that he "knew things were going to get very ugly" and that "it was going to be in the form of dumping a bunch of inventory."

During fiscal year 2006, as Overstock.com's inventory levels, Patrick Byrne and Jason C. Lindsey repeatedly played down any concerns about the pending nightmare that awaited Overstock.com.

April 28, 2006: Earnings conference call for the first quarter of fiscal year 2006

With a disaster looming, Patrick Byrne played down concerns over junk inventory by claiming that they were over:

...we've come out of it now, but we did mark things down in order to flush things through. So that hurt our margins a bit. [Emphasis added.]

 July 28, 2006: earnings conference call for the second quarter of fiscal year 2006

Obviously, Overstock.com did not "come out of it" since it still had more junk inventory to sell. Jason C. Lindsey had discussed the progress of Overstock.com's reduction of inventory levels:

So far, it has sold okay. We are getting rid of it and it does not look like we have - obviously, we are more than adequately reserved, I think, for all of it, but just as far as having sold the last of it, so that there is no more drag on margins, we definitely want to have that happen by the end of the year. [Emphasis added].

November 6, 2006: earnings conference call for the third quarter of fiscal year 2006

Obviously, Overstock.com was not "more than adequately reserved...so that there is no more drag on margins." Patrick Byrne sang a different tune about gross margins and gave a small indication of the fourth quarter disaster that lay ahead:

I am going to put some meat on that, because we think that we can dramatically reduce inventory from here. But to move that amount of inventory, core inventory, we are giving great deals, better than -- well, we are giving great deals and clearing a whole bunch of stuff out, so we will end with extremely fresh inventory and a much smaller amount than you have ever seen us run with as a fraction of sales....
But to do that, to clean out every nook and cranny in the warehouse, is going to require clearance prices on it, so that is why the margins are going to hurt. [Emphasis added.]

Jason C. Lindsey chimed in claiming:

There is $10 million to $20 million worth of stuff in our warehouse now that we do not ever want to have in our warehouse again. We are clearing it out nicely.

Fourth quarter of fiscal year 2006 financial results

Financial results during the fourth quarter of fiscal year 2006 did get quite ugly, in fact very ugly. Revenue had dropped about 6% to $294 million from $315.0 million versus the comparable second quarter of fiscal year 2005. Gross profit margins dropped to 9.3% from 14.0% and net losses continued to grow to $45.6 million from $6.3 million.

During the fourth quarter of fiscal year 2006, as Overstock.com's gross inventories (before reserves) declined from about $73.3 million at the end of the third quarter to about $26.9 million, while inventory reserves rose from about $4.5 million to $6.6 million. The percentage of inventory reserves to gross inventory rose dramatically from 6.14% to 24.52%, or almost a 300% relative increase in reserves.

February 5, 2007: earnings conference call for the fourth quarter of fiscal year 2006

During the fourth quarter earnings conference call, Jason C. Lindsey, Overstock.com's Chief Operating Officer, made the following statements, relating to inventories and gross margins:

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.
...I am pleased that the fourth quarter is now over. We have sold it. Our inventory turns are much higher. Our margins are much higher and it really does feel like we have made a lot of progress there. [Emphasis added.]

The end game

Let's examine some financial information.

During fiscal year 2006, Overstock.com had in fact dumped a bunch of inventory. Gross inventory levels (before reserves) started the year at about $98.5 million and dropped to about $26.9 million by the end of the year, about a $71.6 million drop in inventory. Inventory reserves rose from about $5.2 million at the beginning of the year to about $6.6 million at the end of the year. On a relative basis, inventory reserves went up a staggering 361% from about 5.3% of gross inventory at the beginning of the year to 24.5% of inventory at the end of the year.

Now let's examine the results starting with the first full quarter after Patrick Byrne's undisclosed knowledge that things were going to get "very ugly." From the end of the first quarter of fiscal year 2006 to the last quarter of the fiscal year, Overstock.com's gross inventory (before reserves) dropped by 57.8 million from $84.7 million to about $26.9 million. Inventory reserves rose from about $3.3 million at the end of the first quarter to about $6.6 million at the end of the year. On a relative basis, inventory reserves went up a staggering 529% from about 3.9% of gross inventory at the beginning of the year to 24.5% of inventory at the end of the year.

So Overstock.com's inventory did indeed drop. However, despite the massive drop in inventories, it seems that no progress was made in reducing the level of junk inventory. On either a dollar value basis, or more accurately, on a relative percentage basis, the level of junk inventory had in fact increased.

Overstock.com cannot have two opposing versions of the truth exist simultaneously. If the company's inventory reserves were accurately stated at the end of the fiscal year at $6.6 million, than no progress was made in reducing the level of junk inventory. If Overstock.com made progress in reducing junk inventory, how can the company report such huge reserves at the end of the fourth quarter?

During the year Overstock.com had claimed that the drag on gross margins was a result of selling junk merchandise. At the end of the year, the company claimed that it was pleased with the significant progress it made in reducing junk inventory. If that is true, why was record inventory reserves booked at the end of the fiscal year? If those inventory reserves were accurate, how can their other statements be true?

Excessive inventory reserves in the fourth quarter of fiscal year 2006 would help Overstock.com produce improving financial results in fiscal year 2007. In addition, excessive inventory reserves in the fourth quarter would help Overstock.com cover-up misstatements of inventory reserves in previous quarters.

I have sent all three of my blog posts in this series to Patrick Byrne, Overstock.com's Board of Directors, and separately to Clay Corbus and Joseph J. Tabacco Jr (Audit Committee members). I have asked them to respond to the questions and issues that I have raised. In addition, the Securities and Exchange Commission was Cc'd on the email.

I await their answers.

The ball is in their court.

Written by,

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

Other blogs covering this issue:

September 1, 2007: Mar's Everything - Lies everywhere by Mar

August 27, 2007: Tracy Coenen - Overstock.com cooking the books?

August 27, 2007: Gary Weiss - Patrick Byrne Goes Speechless over Managed Earnings

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