Saturday, July 19, 2008

The SEC stands by while Overstock.com continues to violate Regulation G and overstates EBITDA in latest report

Before we begin let's review some of Overstock.com's history of false and misleading disclosures

Overstock.com (NASDAQ: OSTK) CEO Patrick Byrne likes to call himself a “humble servant” to his company's shareholders and a “market reform advocate” to the investing public, while he and his company have a documented long history of false and misleading disclosures and utterly despicable behavior such as stalking and smearing critics with its in-house black ops team. As previously detailed in this blog, from December 2000 to March 2002, Patrick Byrne had lied about Overstock.com being profitable when the company was never profitable at that time. Overstock.com’s unprincipled management team intentionally violated GAAP in reporting revenues from at least fiscal year 2000 until the SEC Division of Corporation Finance recently forced the company to report revenues in compliance with GAAP. To make matters worse, the company misled the SEC Division of Corporation Finance about the materiality of its revenue accounting errors and therefore violated Statement of Accounting Standards No. 154 by not restating prior period financial statements to correct its revenue accounting errors. In fact, Overstock.com has had only two profitable quarters (Q4 2002 and Q4 2004) in its entire history. At least one of those quarters earnings were materially overstated as a result of Overstock.com's intentional revenue accounting errors that were uncovered by the SEC. To make matters even far worse, as detailed many times in this blog dating back to November 2007, when it comes to non-GAAP disclosures, Overstock.com has continually violated SEC Regulation G and overstated EBITDA in its financial reports filed with the SEC from Q2 2007 forward.

Apparently, Patrick Byrne and his management team feel that they can make their own accounting and SEC disclosure rules on the fly - GAAP and SEC disclosure requirements be damned. In the mean time, the SEC sits by idly while Overstock.com distorts its financial performance to investors.

Overstock.com’s continued material violations of SEC Regulation G governing non-GAAP disclosures such as EBITDA causes it to turn a negative EBITDA to a positive EBITDA

It is incomprehensible that the SEC has so far failed to take any action against Overstock.com for violations of Regulation G, despite being continually informed by this blogger, its recently terminated investigation of the company, and also taking actions against other similarly non-compliant companies to force them to correct such violations.

In Overstock.com’s latest Q2 2008 earnings report, the company improperly reported EBITDA of $1.117 million in violation of SEC Regulation G. Overstock.com’s reported non-compliant EBITDA was overstated by $1.545 million as a result of the company improperly removing from its EBITDA calculations the effects of certain stock-based compensation expenses and improperly reconciling EBITDA to operating loss rather than net loss, in violation of SEC Regulation G. Therefore, had Overstock.com properly reported EBITDA in compliance with SEC Regulation G, the company would have reported a negative EBITDA of $428,000 instead of its non-compliant positive EBITDA of $1.117 million.

The sheer size of Overstock.com’s overstatement of EBITDA is clearly a material accounting error as defined by SEC Staff Accounting Bulletin No. 99. Overstock.com’s overstatement of EBITDA in violation of SEC Regulation G flips a properly calculated negative EBITDA of $428,000 into an improperly reported positive EBITDA of $1.117 million. According the SAB No. 99, one of the main considerations in determining if an accounting error is material is, “whether the misstatement changes a loss into income or vice versa.” Here with Overstock.com, we have a clearly material violation of SEC Regulation G in the company's Form 8-K filed with the Securities and Exchange Commission. See the charts below:

EBITDA incorrectly reported by Overstock.com in violation of SEC Regulation G

Items (in thousands of $)

Three Months Ended 06/30/07

Three Months Ended 06/30/08

Operating income or (loss)

-13,519

-6.317

Depreciation and amortization

7,974

5,887

Stock-based compensation

1,137

1,068

Stock-based compensation to consultants for services

135

329

Stock-based compensation relating to performance share plan

0

150

Issuance of common stock from treasury for 401 (K) matching contribution

113

0

EBITDA, as reported by Overstock.com in violation of SEC Regulation G

-4,160

1,117

EBITDA, as should have been correctly reported by Overstock.com in compliance with SEC Regulation G

Items (in thousands of $)

Three Months Ended 06/30/07

Three Months Ended 06/30/08

Net income or (loss)

-13,768

-6.463

Depreciation and amortization

7,974

5,887

Interest expense

1,027

888

Interest income

-1,078

-740

EBITDA, as should have been correctly reported by Overstock.com in compliance with SEC Regulation G

-5,845

-428

Overstock.com's material overstatement of EBITDA in violation of SEC Regulation G

Items (in thousands of $)

Three Months Ended 06/30/07

Three Months Ended 06/30/08

EBITDA, as reported by Overstock.com in violation of SEC Regulation G

-4,160

1,117

EBITDA, as should have been correctly reported by Overstock.com in compliance with SEC Regulation G

-5,845

-428

Amount of EBITDA overstatement by Overstock.com

1,685

1,545

Percentage of EBITDA overstatement by Overstock.com

40.50%

138.32%

SEC Regulation G defines EBITDA specifically as "earnings before interest, taxes, depreciation, and amortization" but Overstock.com makes up its own EBITDA and violates SEC rules

During the Q2 2008 earnings call, the following exchange took place between CEO Patrick Byrne and CFO David K. Chidester:

Patrick Byrne

Great. Slide number 10. EBITDA and this excludes stock based compensation. Do you want to mention that Dave? Do you want to – ?

David Chidester

Just – there is different ways people calculate EBITDA I think. We just want to make sure it’s clear that our calculation of EBITDA does [ph] include stock based compensation.

Patrick Byrne

Is that the convention?

David Chidester

(inaudible) It’s completely the convention in our industry and I think because it’s a new – it only came about a couple of years ago, everybody pretty much excludes it when they talk about EBITDA and talk about cash earnings.

What David Chidester said is that he thinks Overstock.com can compute EBITDA by eliminating stock-based compensation expenses from its computation and as a result of such a false claim by him, the company reported a materially overstated EBITDA in violation of SEC Regulation G. He further claims that removing stock-based compensation from EBITDA is "completely the convention in our industry." David Chidester's claims about Overstock.com's EBITDA disclosures are flat out false and as the CFO of a public company, he cannot claim ignorance to SEC Regulation G. That "everyone else is doing it" excuse was previously used by both David Chidester and Patrick Byrne as justification for the company's intentional revenue accounting errors uncovered by the SEC. However, SEC Staff Accounting Bulletin No. 99 specifically states that "Authoritative literature takes precedence over industry practice...."

In this case, Overstock.com improperly removed stock-based compensation expenses to flip a properly calculated negative EBITDA in compliance with Regulation G into an improperly reported positive EBITDA. In fact, for public companies the SEC provides specific rules for calculating EBITDA under SEC Regulation G. Overstock.com clearly cannot exclude stock-based compensation expenses from EBITDA.

According to the SEC Division of Corporation Finance Regulation G guidance provided by their "Frequently Asked Questions Regarding the Use of Non-GAAP Financial Measures" EBITDA refers specifically to “earning before interest, taxes, depreciation and amortization." See below:

Question 14: Section I of the adopting release describes EBIT as "earnings before interest and taxes" and EBITDA as "earnings before interest, taxes, depreciation and amortization." What GAAP measure is intended by the term "earnings"? May measures other than those intended by the description in the release be characterized as "EBIT" or "EBITDA"? Does the exception for EBIT and EBITDA from the prohibition in Item 10(e) (1) (ii) (A) of Regulation S-K apply to these other measures?

Answer 14: "Earnings" is intended to mean net income as presented in the statement of operations under GAAP. Measures that are calculated differently than those described as EBIT and EBITDA in the adopting release should not be characterized as "EBIT" or "EBIDTA." Instead, the titles of these measures should clearly identify the earnings measure being used and all adjustments. These measures are not exempt from the prohibition in Item 10(e) (1) (ii) (A) of Regulation S-K.

Note: Bold print and italics added by me.

Therefore, the intended meaning of “earnings” for EBITDA under Regulation G is “net income as presented in the statement of operations under GAAP.” EBITDA can only be computed as earnings (meaning net income or loss) before interest, taxes, depreciation, and amortization and the SEC requires that “measures that are calculated differently than those described as…EBITDA in the adopting release [Regulation G] should not be characterized as EBITDA.” Net income, not operating income as used by Overstock.com, is the starting point towards computing EBITDA and stock-based compensation expenses cannot be excluded from EBITDA according to SEC Regulation G.

David Chidester’s above comments about Overstock.com's EBITDA disclosures are flat out false! On May 13, David K. Chidester, Senior Vice President – Finance sold 2,766 shares at an average price of about $27.83 per share of and pocketed gross proceeds totaling about $77,000. After Overstock.com’s Q1 2008 earnings call, the company’s stock price plunged 41.12% or $11.31 to close at just $16.31 per share. As David Chidester cashes out, Overstock.com shareholders are bearing the losses.

The SEC has taken action against other non-compliant companies violating Regulation G but has utterly failed to take action against Overstock.com for similar violations

In a previous blog post, I detailed how CGG Veritas, like Overstock.com, improperly removed stock-based compensation expense from its reported EBITDA in violation of SEC Regulation G. The SEC Division of Corporation Finance informed CGG Veritas that:

The acronym EBITDA refers specifically to earning before interest, tax, depreciation and amortization. However, your measure also adjusts earnings for stock option expense. We will not object to your using such a measure as a liquidity measure but request that you rename it to avoid investor confusion.

Note: Bold print and italics added by me.

As a result of the SEC’s review, CGG Veritas changed its non-compliant EBITDA measure to EBITDAS or earnings before interest, taxes, depreciation, amortization, and stock-based compensation. CGG Veritas responded to the SEC that, "we will in future filings refer to the non-GAAP measure in question as 'EBITDAS' which we will define as 'earnings before interest, tax, depreciation, amortization and share-based compensation cost' ….”

As detailed above, Overstock.com, just like CGG Veritas, improperly removed the effects of stock-based compensation expenses from its non-compliant EBITDA disclosures in violation of Regulation G. Yet the SEC has continued to fail to take action against Overstock.com to correct such non-compliant EBITDA disclosures despite being directly informed by this blogger.

In that same blog post, I detailed how CKX Inc, like Overstock.com, improperly reconciled its non-compliant EBITDA to operating income or loss rather than net income. The SEC notified CKX Inc.:

Reference is made to your presentation of the non-GAAP financial measure, EBITDA, in the table of your historical and pro forma financial information for the year ended December 31, 2004. We note that you define EBITDA as income or loss from continuing operations before interest expense, income tax expense (benefit), depreciation and amortization, and consider it to be an important supplemental measure of your operating performance which is used by management to evaluate the performance of the Company. However, it appears your definition of EBITDA does not comply with the guidance set forth in Question 14 of the “Frequently Asked Questions Regarding the Use of Non-GAAP Financial Measures.” Question 14 states that the term “earnings” is intended to mean net income as presented in the statement of operations under GAAP and further, measures that are calculated differently than those described as EBIT or EBITDA should not be characterized as “EBIT” or “EBITDA.” In this regard, please revise your calculation of EBITDA such that it is computed as net income (loss) (rather than income or loss from continuing operations) before interest expense, income tax expense (benefit), depreciation and amortization. Alternatively, if you believe your current presentation of your non-GAAP measure is appropriate, but has been characterized inappropriately as EBITDA, revise your presentation and supplementally tell us in detail how it complies with FR-65.

Note: Bold print and italics added by me.

The SEC told CKX Inc. that its non-compliant EBITDA must be computed by revising their "calculation of EBITDA such that it is computed as net income (loss) (rather than income or loss from continuing operations) before interest expense, income tax expense (benefit), depreciation and amortization." Any other calculation cannot be called EBITDA. However, Overstock.com, just like CKX Inc., improperly reconciled its non-compliant EBITDA to operating income or loss rather than net income or loss and the SEC has utterly failed to take action against Overstock.com to correct its non-compliant EBITDA disclosures despite being notified by this blogger.

CKX responded to the SEC:

The Registrant has revised its presentation in the Summary Historical and Pro Forma Financial Data to include operating income before depreciation and amortization ("OIBDA"). All references to EBITDA have been removed. The Registrant has revised its disclosures to reconcile OIBDA to operating income which is the most directly comparable financial measure calculated and presented in accordance with GAAP.

Note: Bold print and italics added by me.

Therefore, CKX renamed its non-compliant EBITDA disclosure as OIBDA or operating income or loss before depreciation and amortization and the company was able to remove losses from discontinued operations from its non-GAAP financial measure.

What is the appropriate term for Overstock.com’s non-compliant EBITDA financial measure?

Overstock.com, like CKX, improperly used operating income or loss as the starting point to compute its non-compliant EBITDA calculation. In addition, Overstock.com, like CGG Veritas, improperly removed stock-based compensation expenses from its non-compliant EBITDA calculation. Perhaps Overstock.com's non-compliant EBITDA should be renamed OIBDAS or operating income or loss before depreciation, amortization, and stock-based compensation expense. Note: Overstock.com does not have income tax expenses due to its losses. However, this blogger has directly notified Overstock.com Audit Committee member Joseph J. Tabacco Jr. of the company's non-compliant EBITDA disclosures and the company has failed, just like the SEC, to address its EBITDA reporting errors.

What’s going on at the SEC?

I am beginning to believe that our present SEC is not of the same caliber that I feared as the criminal CFO of Crazy Eddie in the 1980s. They are overwhelmed and under-resourced. Instead, they using their highly taxed resources to chase delusional conspiracy theories such as those blaming short sellers on problems related to the subprime crises effecting Fannie Mae and Freddie Mac. I suggest that you read Joe Nocera's blog post entitled, "First, Let's Kill All Short-Sellers." Perhaps that explains why companies like Overstock.com can thumb their noses at SEC rules while the SEC drops investigations of such companies.

As detailed above, Overstock.com's stock price on Friday 41.12% or $11.31 to close at just $16.31 per share after the company's misleading earnings release. Eric Savitz, in the Barron's Tech Trader Daily blog noted:

Stifel Nicolaus analyst Scott Devitt this morning cut his rating on Overstock.com (OSTK) to Sell from Hold. He notes that the company, which reported Q2 financial results this morning, trades for 21×2009 EBITA, “the highest multiple in the sector.”

Devitt says the company has had two consecutive quarters of mid-20% growth, but that it has had “fairly easy comps,” and that growth could drop into the low-to-mid teens by 2009.

Note: Bold print and italics added by me.

However, Gary Weiss noted in his blog that:

Sam [Antar] has specifically warned that Overstock was distorting the "growth" numbers reported to the public. He set forth his case in exhaustive detail. But analysts and the clowns at the SEC -- who just gave Overstock's accounting a clean bill of health -- paid no attention.

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

Acclaimed forensic accountant, author, and blogger Tracy Coenen asked:

I keep wondering why Pricewaterhouse Coopers doesn’t catch this material error in calculating a figure that is heavily touted in reports to investors. Rumor has it that they review the quarterly reports, but this makes me wonder.

Note: Bold print and italics added by me.

The tragedy of American capitalism is that most investors rely on incompetent or at the very least lazy and spineless Wall Street analysts for research and inadequately trained but similarly spineless auditors to make sure financial reports are free of material errors. This tragedy is further compounded by an overwhelmed and under-resourced SEC chasing delusional conspiracy theories touted by company managements who are unwilling to take responsibility for their misdeeds.

To be continued….

Written by:

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

Disclosure: Not long or short Overstock.com, CGG Veritas, and CKX. Inc.

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