Thursday, October 23, 2008

My Questions for Overstock.com CEO Patrick Byrne Regarding Upcoming Earnings Call for Q3 2008

During the Q2 2008 earnings call, Patrick Byrne asked if I had any “questions” even though he knew that I was not on the call. Therefore, I am taking Patrick Byrne up on his invitation to ask questions for Overstock.com’s (NASDAQ: OSTK) upcoming Q3 2008 earnings call tomorrow on Friday, October 24.

Before, asking each of my questions below, I provide the context of my questions. I look forward to an articulate and detailed separate response to each of my questions and will publish Byrne’s answers on my blog.

Let’s see if Patrick Byrne, who calls himself a transparent CEO, has the guts to answer each and every question.

Using Earnings before interest, taxes, and depreciation (EBITDA) in Overstock.com’s financial reports

On April 23, 2004, Patrick Byrne appeared on the Kudlow and Cramer show on CNBC and commented about EBITDA:

Well, first of all, I’m all about GAAP. I have been so critical of the companies that do–I don’t believe in one-time charges; I don’t believe in EBITDA. If somebody talks EBITDA, put your hand on your wallet; they’re a crook.

Note: Bold print and italics added by me.

In January 2006, Patrick Byrne made the following comments about EBITDA to Tom Mullaney from Business Week in an email:

I think “EBITDA” is the stupidest thing I ever heard emanate from Wall Street (no small feat), I … don’t begin to know how to answer. I suppose I could go and recast all my numbers into EBITDA (or for that matter, “pro forma”) but I think I’ll do something more valuable with my time, like alphabetize my CD’s by, “Name of drummer.”

Note: Bold print and italics added by me.

In March 2006, Patrick Byrne told Greg Sandoval from c/net news.com:

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

Despite Patrick Byrne’s comments above, since Q2 2007, Overstock.com has been reporting what it claims is EBITDA in reports filed with the SEC and unlike Overstock.com, Amazon does not report EBITDA in reports filed with the SEC.

Questions for Patrick Byrne

Based on your comments above, do you believe that you are “crook” for using EBITDA in Overstock.com’s financial reports and do you believe that investors should “put their hand on” their wallets and not consider investing in your company?

If you believe that “EBITDA” is the “stupidest thing” you “ever heard emanate from Wall Street” and a “phony accounting standard—pro forma” why does Overstock.com use EBITDA in its financial reports?

Did you flip flop your views on EBITDA when it was advantageous to use it in Overstock.com's reports filed the SEC?

Are Overstock.com’s EBITDA disclosures in compliance with SEC Regulation G?

Securities and Exchange Commission Regulation G governs the use of EBITDA and other non-GAAP financial measures. According to the SEC Division of Corporation Finance Regulation G guidance provided in 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 and not operating 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.”

However, Overstock.com defines its reported EBITDA as follows:

Our measure of “EBITDA” is a non-GAAP financial measure. EBITDA, which we reconcile to “Operating loss” in our income statement, is earnings before interest, taxes, depreciation, amortization and stock-based compensation.

Note: Bold print and italics added by me.

Therefore, Overstock.com improperly reconciled its reported EBITDA to operating loss instead of net loss and the company also improperly eliminates “stock-based compensation” from its EBITDA computation. Let’s examine, the SEC’s actions, regarding two other companies who reported EBITDA that was not complaint with Regulation G, before I ask Patrick Byrne additional questions about Overstock.com's EBITDA calculations.

CKX Inc. improperly reconciled EBITDA to “income from operations”

Like Overstock.com, CKX reconciled EBITDA to “income or loss from operations” and similarly they both had losses from discontinued operations. As a result of using operating income or loss from operations, rather than net income or loss, as the starting point towards computing EBITDA, both CKX and Overstock.com overstated EBITDA by at least the amount of losses from discontinued operations. The SEC notified CKX:

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 to revise their EBITDA calculation from “income or loss from continuing operations before interest expense, income tax expense (benefit), depreciation and amortization” to “net income (loss) (rather than income or loss from continuing operations) before interest expense, income tax expense (benefit), depreciation and amortization."

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 before depreciation and amortization and the company was able to reconcile OIBDA to operating income. Therefore, CKX was able to remove losses from discontinued operations from its non-GAAP financial measure. Overstock.com Audit Committee member Joseph J. Tabacco Jr, was alerted by me via email (return receipt received) that Overstock.com, like CKX, improperly reconciled its reported EBITDA to operating income or loss rather than net income or loss.

Questions for Patrick Byrne

Why does Overstock.com continue to improperly reconcile its reported EBITDA to operating loss rather than net loss?

Why not rename Overstock.com’s non-compliant EBITDA disclosure to a more appropriate name to comply with Regulation G?

CGG Veritas, improperly eliminated “stock-based” compensation from its reported EBITDA computation

Another company, CGG Veritas, like Overstock.com, improperly eliminated “stock-based” compensation from its reported EBITDA computation and as a result overstated its reported EBITDA by the amount of stock-based compensation. The SEC notified CGG Veritas:

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.

CGG Veritas responded to the SEC:

In response to the Staff’s comment, 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”, and will reconcile to net cash provided by operating activities as presented on the Company’s consolidated statements of cash flows.

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.

Overstock.com Audit Committee member Joseph J. Tabacco Jr, was alerted by me via email (return receipt received) that Overstock.com, like CGG Veritas, improperly removed stock-based compensation from its reported EBITDA calculation.

Questions for Patrick Byrne

Why does Overstock.com continue to improperly remove stock-based compensation from its reported EBITDA?

Why not rename Overstock.com’s non-compliant EBITDA disclosure to a more appropriate name to comply with Regulation G?

Based on the SEC actions regarding both CKX Inc. and CGG Veritas under SEC Regulation G, why not rename Overstock.com’s improperly reported EBITDA to OIBITAS or operating income or loss before interest, taxes, depreciation, and stock-compensation expense to comply with SEC Regulation G?

Improperly reported EBITDA calculation by Overstock.com results in overstatement of EBITDA in violation of SEC Regulation G

Since Overstock.com improperly reconciles EBITDA to operating loss rather than net loss, the company’s reported EBITDA is overstated by the amount of loss from discontinued operations in certain accounting periods. In addition, since Overstock.com improperly eliminates stock-based compensation costs from EBITDA, the company’s reported EBITDA is overstated by such amounts.

In Overstock.com’s “CEO Owner’s Guide” Patrick Byrne made the following comments:

I wish to set a gold standard in communicating with candor your firm's results. In our public SEC filings we chose principles at the conservative edge of GAAP….

Note: Bold print and italics added by me.

Question for Patrick Byrne

Do you believe that reconciling EBITDA to operating loss and eliminating stock-based compensation from EBITDA, both of which overstated Overstock.com reported EBITDA in violation of SEC Regulation G, is consistent with your “gold standard” and choosing “principles at the conservative edge of GAAP” as enumerated above?

Inconsistent EBITDA disclosures by Overstock.com

In certain accounting periods, Overstock.com has eliminated part of its restructuring costs from EBITDA while in other accounting periods such restructuring costs are included in its EBITDA calculations. For example, Overstock.com’s Q2 2007 10-Q and Q3 2007 10-Q does not eliminate restructuring charges from both is reported quarterly and year-to-date reported EBITDA. I note that during fiscal year 2007, all of restructuring charges totaling $12.283 million occurred in Q1 and Q2 2007 and no other quarters. In contrast, in Overstock.com’s fiscal year 2007 10-K , the company's year-to-date EBITDA eliminates $2.169 million of the $12.283 restructuring charges that were included in previously reported year-to-date EBITDA calculations in Q2 2007 and Q3 2007.

Question for Patrick Byrne

Why did Overstock.com use inconsistent calculations for computing its reported EBITDA?

Patrick Byrne claims a "gold standard in communicating with candor" Overstock.com's results

As I detailed above, Patrick Byrne claims to “wish to set a gold standard in communicating with candor” Overstock.com results. As detailed above, in March 2006, he told Greg Sandoval from c/net news.com:

We have a plan this year that we should cross the billion-dollar mark…. 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 by me.

Both revenues and reported EBITDA fell way off the mark touted by Byrne. In fiscal year 2006, Overstock.com did not “cross the billion-dollar mark” in revenues and instead reported revenue of only $788.15 million. In addition, Overstock.com did not have “an EBITDA-profitable year” and instead improperly reported a non-compliant EBITDA of negative $55.718 million which understated Overstock.com's negative EBITDA or rather overstated the company's EBITDA performance. About a year later, on April 25, 2007, during the Q1 2007 earnings conference call, Patrick Byrne made the following startling admission in contrast to his comments to Greg Sandoval, a year earlier:

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.

Questions for Patrick Byrne

Since both your interview with Greg Sandoval and your “game plan” quoted above occurred during the same quarter (Q1 2006), why did you wait almost an entire year to disclose that you knew that things were going to get "really ugly" and the company was going to have to "take medicine"?

Do you believe that waiting almost an entire year to disclose your “game plan” is consistent with your “wish to set a gold standard in communicating with candor” Overstock.com results?

Questionable disclosures about inventories

On December 15, 2006, Overstock.com sold 2.734 million shares of stock and received a cash infusion of about $40 million. At that time, investors were not informed by Patrick Byrne that he already knew that things were going to get "really ugly" and the company was going to have to "take medicine." What followed was "really ugly" in the form of declining revenues, negative gross margins on direct sales, massive increases in inventory reserves, and huge record losses in Overstock.com's final quarter of fiscal year 2006.

On February 5, 2007, Overstock.com disclosed that Q4 2006 revenues declined to $297.47 million from $317.98 million or a 6.5% reduction. During the final quarter, company lost a record $40.7 million and reported negative gross margins on direct sales. During the Q4 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.... We have sold it.”

Just a few short weeks later, Overstock.com released its 10-K for fiscal year 2006. In that filing, the company reported its highest ever level of inventory reserves, making it quite clear that the slow moving inventory had not been moved (contrary to Lindsey’s earlier assertion).

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.

But, the bad inventory wasn’t gone. This is clear because 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.

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?

As detailed above, during the earnings conference call for the next quarter (first quarter fiscal year 2007) Patrick Byrne made the startling admission of Overstock.com’s previously undisclosed “game plan...of what was going to have to happen" during fiscal year 2006. He "knew things were going to get really ugly." Patrick Byrne's comment reinforced Jason C. Lindsey’s comment that the fourth quarter of fiscal year 2006 was “very bad…bad on purpose.”

Questions for Patrick Byrne

Why did Jason C. Lindsey say “we used the fourth quarter to get rid of all the slow-moving inventory” and "we have sold it" when in fact, afterwards, it was disclosed that inventory reserves increased in both total dollars and relative amounts to gross inventories?

Was Jason Lindsey misinformed, trying to mislead investors, or outright lying?

Did Overstock.com defer recognition of adequate inventory reserves until after Q3 2006 by making a "catch up" adjustment to inventory reserves in Q4 2006?

Why did Overstock.com wait until months after it sold 2.734 million shares of stock and received a cash infusion of about $40 million to disclose that management already knew that things were going to get "really ugly" and the company was going to have to "take medicine"?

If we take Jason C. Lindsey at his word that Overstock.com “used the fourth quarter to get rid of all the slow-moving inventory” and that the company really “sold it,” were inventory reserves deliberately inflated in Q4 2006 to help increase earnings or reduce losses in future accounting periods by reversing such reserves?

Additional Comments

Since Patrick Byrne invited me to ask questions for Overstock.com’s earnings call I look forward to his detailed responses to each individual question. As I said, I will post his responses on my blog.

The ball is now in Patrick Byrne’s court. Let’s see if Patrick Byrne has the guts to answer my questions.

To be continued….

Written by,

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

Disclosure: Not long or short Overstock.com

Update:

A day after this blog post, Overstock.com announced new accounting errors and as a result, the company is restating all financial reports dating back to 2003. During the Q3 2008 earnings call, management attempted to address issues raised in this blog post with new false and misleading statements. After listening to management's latest round of lies and distortions, I posted a message to Overstock.com's management here. A detailed response to Overstock.com is posted here.

2 comments:

Anonymous said...

Sam, now why would he answer your questions when you start out by calling him a crook? Furthermore, how much time do you think he should dedivcate to you? clearly to answer all these questions you ask will take a considerable amount of time and thus leave time for nothing else.

I can't wait for your spin after the call about how Byrne refused to repond to the 100 questions and accusatins you posed to him via your web site. How much self-importance lives ithin that tiny body of yours?

Sam E. Antar said...

Patrick Byrne defined his own actions as crooked. On CNBC, he said:

"I don’t believe in EBITDA. If somebody talks EBITDA, put your hand on your wallet; they’re a crook."

Patrick Byrne invited me to ask questions and I have submitted my questions.

The ball is in his court.

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