Thursday, January 17, 2008

Are certain former Overstock.com directors jumping ship on Patrick Byrne?

A see no evil, hear no evil Board of Directors

Certain current and former Overstock.com (NASDAQ: OSTK) directors have filed a Special Motion to strike Copper River Partners LP (formerly Rocker Partners) countersuit against them as individual defendants. The group includes John J. Byrne (father of Overstock.com CEO Patrick Byrne and a former Director), Allison H. Abraham (current Director), Jason C. Lindsey (recently resigned as President, Chief Operating Officer, and Director), and John A. Fisher (former Director).

It's management's fault, they did it and we had nothing to do with it

Perhaps the most puzzling disclosure is that the Director Defendant's:

...did not, in fact, authorize the August 2005 filing" of Overstock.com's lawsuit against Copper River and Gradient.... It was a management-level decision made at a time when Lindsey was neither an officer nor a director.

Note: Bold print and italics added by me.

Is Overstock.com's Director Defendant's which include Patrick Byrne's father, running for cover and trying to lay the blame on CEO Patrick Byrne? In a previous blog post entitled, "Overstock.com vs. Gradient and Rocker Part 1: Patrick Byrne and his Three Stooges," I analyzed the conflicting, inconsistent, and contradictory allegations of the three former Gradient employees whom Overstock.com is relying on as its main witnesses. Cooper River's countersuit against Overstock.com details false, misleading, and deceptive disclosures by the company and its management dating from before Overstock.com's initial public offering in June 2002 through the current fiscal year. The countersuit further alleges a conspiracy to inflate the value of Overstock.com's stock to finance the company's perennially money losing operations, after it went public.

It's the auditor's fault, even though we are their bosses, we rely on them for "advice and approval"

Another troubling aspect of the Director Defendant's motion is the claim by one current and another former Audit Committee Member of reliance on Overstock.com's auditors which contradicts the company's previous disclosures:

The actions taken by Abraham and Fisher as members of Overstock.com's Audit Committee were based upon the advice and approval of independent auditors from PricewaterhouseCoopers....

Note: Bold print and italics added by me.

However, disclosures in Overstock.com's "Report of the Audit Committee," included in the company's previous proxy statement, contradict claims made by Abraham and Fisher in the Director Defendant's motion:

The Audit Committee serves a board-level oversight role, in which it provides advice, counsel and direction to management and the auditors on the basis of the information it receives, discussions with management and the auditors and the experience of the Audit Committee's members in business, financial and accounting matters.

Note: Bold print and italics added by me.

How can Allison H. Abraham and John A. Fisher claim that their actions "were based on the advice and approval of independent auditors" when as Audit Committee members they served a "board-level oversight role, in which it provides advice, counsel and direction to management and the auditors...."?

Apparently Abraham and Fisher are concerned about various misleading statements made during various earnings conference calls by Jason C. Lindsey (who recently resigned as President, Chief Operating Officer, and Director) about Overstock.com's reported inventory reserves as they down play his comments. For example, they claim that:

Lindsey's comment in 2006 that reserves were adequate is entirely benign and was based upon a determination made in consultation with the PricewaterhouseCoopers auditors.

Note: Bold print and italics added by me.

Whether or not Overstock.com's auditors were consulted does not alleviate its management of any responsibility for the integrity of the company's financial reporting. According to Overstock.com's "Report of the Audit Committee in its last proxy statement:

Management is responsible for the preparation, presentation and integrity of the Company's financial statements, accounting and financial reporting principles, and internal controls and procedures designed to ensure compliance with accounting standards, applicable laws and regulations.

Note: Bold print and italics added by me.

Remember, as detailed above, that Overstock.com's Audit Committee, "provides advice, counsel and direction to management and the auditors..." Therefore, false and misleading financial reporting is clearly the Audit Committee's responsibility, too. According to Overstock.com's Audit Committee Charter:

...the purpose of the Audit Committee is to provide general oversight of the Company's financial reporting, internal control and audit functions.

Note: Bold print and italics added by me.

We have to wonder, who are these monkey's trying to fool?

Let's examine certain disclosures by Overstock.com and its management regarding inventories and inventory reserves in fiscal year 2006

During Overstock.com's first quarter 2007 earnings conference call, Patrick Byrne revealed a previously undisclosed plan for earnings management dating back to the first quarter of fiscal year 2006:

We had our game plan. Really, we had our game plan as of Q1 last year [2006] 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 by me. [Bracketed] information added for clarity.

However, Overstock.com did not make a timely disclosure that "things were going to get really ugly." According to Overstock.com's news release for the first quarter of fiscal year 2006, the company reported gross margins of 14.0% compared to 14.9% in 2005. With an undisclosed disaster looming, during the first quarter fiscal year 2006 earnings conference call, Patrick Byrne played down concerns about Overstock.com's inventory problems:

...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.

Note: Bold and italics added by me.

According to Overstock.com's 10-Q filed about two weeks later, the company reported that inventory reserves had dropped to $3.3 million at the end of the first quarter of fiscal year 2006 from $5.241 million at the end of the previous quarter. In addition, inventory reserves as a percentage of gross inventory had dropped to 3.90% of gross inventory from 5.32% of gross inventory at the end of the previous quarter. In other words, the relative level inventory reserves reportedly dropped about 26.7%.

After reporting its second quarter fiscal year 2006 results, it was quite clear that Overstock.com did not "come out of it" and had not alleviated its inventory problems. According to Overstock.com's news release for the second quarter of fiscal year 2006, the reported gross margins of 14.4% compared to 15.1% in 2005. However, during the second quarter earnings conference call, Jason C. Lindsey reassured investors:

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.

Note: Bold and italics added by me.

Jason C. Lindsey had claimed that "So far it has sold okay. We are getting rid of it...." However, as detailed above, Patrick Byrne had previously claimed after the first quarter that, "...we've come out of it now, but we did mark things down in order to flush things through."

Now, according to Overstock.com's second quarter fiscal year 2006 10-Q, the company reported that total inventory reserves had slightly increased to $3.4 million at the end of the second quarter of fiscal year 2006 from $3.3 million at the end of the previous quarter. In addition, inventory reserves as a percentage of gross inventory had increased to 4.35% of gross inventory from 3.90% of gross inventory during the previous quarter. In other words, the relative level inventory reserves reportedly increased about 10% and Jason C. Lindsey had now claimed that "we are more than adequately reserved...so there is no more dragon margins."

Obviously, Overstock.com was not "more than adequately reserved...so that there is no more drag on margins." According to Overstock.com's news release for the third quarter of fiscal year 2006, reported gross margins continued to decline, in contrast to Lindsey's previous claim that the company "was more than adequately reserved," so there would be "no more drag on margins". The company reported gross margins of 14.5% compared to 15.7% in 2005.

During Overstock.com's third quarter earnings conference call, Patrick Byrne finally sang a different tune about gross margins and gave a slight hint 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.

Note: Bold and italics added by me.

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.

Note: Bold print and italics added by me.

According to Overstock.com's third quarter fiscal year 2006 10-Q, the company reported that total inventory reserves had increased to $4.5 million at the end of the second quarter of fiscal year 2006 from $3.4 million at the end of the previous quarter. In addition, inventory reserves as a percentage of gross inventory had increased to 6.14% of gross inventory from 4.35% of gross inventory during the previous quarter. In other words, the relative level inventory reserves reportedly increased about 41.1%.

Was Overstock.com "more than adequately reserved" this time around? After carefully examining Overstock.com's fourth quarter results, it is clear that the company still failed to maintain adequate inventory reserves at the end of the third quarter.

According to Overstock.com's news release for the fourth quarter of fiscal year 2006, overall gross margins dropped to 12.8% compared to 15.0% in 2005. However, gross margins for Overstock.com's direct sales had dropped to an astounding negative 3.1% and most of the company's inventory on hand is to support its direct sales. The company had lost an estimated $7 million to $11 million (my calculations) from dumping slow moving inventory and it was apparently under-reserved at the end of its third quarter. Note: Overstock.com only handles sales return inventories for its fulfillment sales.

During the fourth quarter fiscal year 2006 earnings conference call, but before Overstock.com had released its 10-K report that included inventory reserve disclosures, Jason C. Lindsey explained Overstock.com’s negative gross margins and lower inventory levels as follows:

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.

Note: Bold print and italics added by me.

The key words are “I admit they are very bad, they were bad on purpose… we used the fourth quarter to get rid of all the slow moving inventory.”

But, the bad inventory wasn’t gone. This is clear because inventory reserves rose from about $4.5 million at the end of the third quarter to about $6.6 million at the end of the fouth quarter. On a relative basis, inventory reserves went up a staggering 299% from about 6.14% of gross inventory at the end of the third quarter to about 24.52% of inventory at the end of the fourth quarter. How could Overstock.com have “sold it” and gotten “rid of all the slow moving inventory” if the company actually estimated that it had more slow moving inventory in both absolute dollars and relative amounts?

Perhaps Overstock.com was burying its inventory mistakes as it carried out Patrick Byrne's yet undisclosed "game plan." During the second quarter fiscal year 2007, earnings conference call Jason C. Lindsey revealed:

To support this level of sales and have $17 million of inventory when at the same time a year ago [2006] I think we had close to $80 million, the amount of mistakes that can be buried in that are much smaller.

Note: Bold print and italics added by me. Bracketed information added by me for clarity.

Examine the chart below in light of Jason C. Lindsey's statement that "the amount of mistakes that can be buried" are much smaller as inventory levels decline:

Selected Inventory Information from Overstock.com's 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)

98,510

84,651

78,222

73,282

26,859

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

5,241

3,300

3,400

4,500

6,585

Net Inventory (in millions of dollars)

93,269

81,351

74,822

68,782

20,274

Percentage of Reserve for Obsolete and Damaged Inventory to Gross Inventory

5.32%

3.90%

4.35%

6.14%

24.52%

On December 15, 2006 Overstock.com had received a long awaited equity infusion of about $40 million after the company had cancelled a previously planned equity offering after the Securities and Exchange Commission launched a formal order of investigation on May 9, 2006. Was Overstock.com burying its inventory “mistakes” until after its equity infusion of about $40 million on December 15, 2006?

Just take a look at the huge increase in the relative amount of reported inventory reserves at the end of the fourth quarter, after Overstock's equity infusion on December 15, 2007 from 6.14% of gross inventory at the end of the third quarter to 24.52% of gross inventory at the end of the fourth quarter or about a 299% relative increase in inventory reserves.

Finally, consider Jason C. Lindsey's claim at the end of the fourth quarter of fiscal year 2006 that, “I admit they are very bad, they were bad on purpose…. We used the fourth quarter to get rid of all the slow moving inventory.” It is clear, as later disclosed in its 10-K, that Overstock.com did not get rid of "all" of its "slow moving inventory" as Jason C. Lindsey had claimed. It still had such inventories and it had it in record numbers.

Apparently, Overstock.com's fourth quarter fiscal year 2006 results were "....were very bad, they were very bad on purpose.....," as Jason C. Lindsey has claimed. As detailed above, Patrick Byrne had an undisclosed "game plan" that "things were going to get really ugly and the company was going to have take medicine." Overstock.com took its "medicine" in the fourth quarter of fiscal year 2006 as inventory reserves rose to record levels, even though Jason C. Lindsey had disclosed that "We used the fourth quarter to get rid of all the slow moving inventory." If they sold it, why did they still have it in record numbers as indicated by the significant increase in inventory reserves?

Are certain defendant directors now worried about possible earnings management by Overstock.com?

Do Overstock.com's Defendent Directors really believe that the Court or a future jury will buy their claim that "Lindsey's comment in 2006 that reserves were adequate is entirely benign," in light of Overstock.com's reported declines in gross margins and massive increases in inventory reserves, that followed? Are they playing the "being stupid is not a crime" game?

The SEC does not seem to be buying it as its investigation of Overstock.com continues and Patrick Byrne is the admitted target of their probe. In light of Jason C. Lindsey joining the Defendent Director's special motion, it is now apparent that Jason C. Lindsey had other reasons for his sudden resignation than what he previously disclosed.

Written by:

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

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