Sunday, November 02, 2008

What Overstock.com Did Not Tell Investors About Latest Accounting Errors

Playing down the material impact of newly disclosed accounting errors

Overstock.com’s (NASDAQ: OSTK) recently announced restatements of prior financial reports dating back to 2003, caused greater material distortions of reported financial performance, than the company's management team has led investors to believe, in their comments made during the Q3 2008 earnings call.

As I detailed in my last blog post, Overstock.com surprised investors and reported that it is restating all financial reports dating back to 2003, due to a newly disclosed accounting error relating to customer refunds and credits. The company disclosed that all previous financial reports issued from 2003 to Q2 2008 “should no longer be relied upon.”

The latest customer refund and credit accounting errors follow a string of material accounting errors that have plagued Overstock.com throughout its history. Earlier this year, the Securities and Exchange Commission discovered that Overstock.com did not report revenues in compliance with GAAP, since its inception. In 2006, the company disclosed inventory accounting errors for fiscal years 2002 to 2005. Apparently, Overstock.com cannot maintain a straight set of books.

Overstock.com's accounting errors have resulted in $10 million of additional losses on top of $255 million reported to date by a company that never had a profitable year. Shareholders' equity was completely wiped out and is now at negative $3.6 million. Reported earnings for Overstock.com's only two profitable quarters (back in Q2 2002 and Q 2004) are highly suspect.

So far, Overstock.com has provided only limited disclosures about the full impact of its latest round of accounting errors. The company did not provide restated financial reports for each separate quarter from 2003 to 2007, though it did provide restated summary annual reports from 2003 to 2007. However, the company did provide restated financial reports for Q3 2007 (for comparison with Q3 2008, its latest quarter), Q1 2008, and Q2 2008. By just examining Q1 and Q2 2008's restated financial reports, we can see how Overstock.com's accounting errors caused significant material distortions in financial results for individual quarters.

The Devil is Always in the Details Left Out and Avoided by Overstock.com

During the Q3 2008 earnings call, CFO David Chidester played down the significance of Overstock.com’s recently disclosed accounting errors by emphasizing its impact on revenues over a 5-1/2 year period, rather than discussing its much greater distortion of reported earnings and EBITDA for individual quarters:

…the effect is going to be on a cumulative basis is a reduction of revenue of $12.9 million over that 5-1/2 year period [fiscal years 2003 to 2007 and the first six months of fiscal year 2008] and a reduction in net income of $10.3 million. Just for some frame of reference, you can see that adjustment to revenue represents less than 0.5% of our revenue over that time period, and all but $1.7 million of the adjustment to net income relates to previous to 2008.

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

Apparently, David Chidester wants investors to consider Overstock.com's accounting errors in terms of the company's "less than 0.5%" overstatement of revenues over a 5-1/2 year period. He avoided leveling to investors how "$1.7 million of the adjustment" significantly overstated earnings and EBITDA in Q1 and Q2 2008, as I will describe below. Relatively small adjustments to a quarter's revenues have a much greater relative impact on reported quarterly net income or losses, earnings per share, EBITDA, and trends in earnings.

Analysis of Impact of Customer Refund and Credit Accounting Errors on Q1 and Q2 2008

A careful analysis of Overstock.com’s preliminary adjustments for accounting errors in Q1 and Q2 2008 show a significant material overstatement of previously reported earnings and EBITDA. The company left out any analysis of the impact of accounting errors on reported EBITDA for each period, and therefore, I computed it myself.

Q1 2008

(In thousands $ except EPS)

Originally Reported

Adjustment for Accounting Error

Estimated Restatement

Percentage Overstatement

Net income or (loss)

(3,909)

(800)

(4,709)

20.47%

EPS

(0.17)

(.04)

(0.21)

23.53%

Reported EBITDA

3,524

(800)

2,724

29.37%

Q2 2008

(In thousands $ except EPS)

Originally Reported

Adjustment for Accounting Error

Estimated Restatement

Percentage Overstatement

Net income or (loss)

(6,463)

(900)

(7,363)

13.93%

EPS

(0.28)

(0.05)

(0.33)

17.86%

Reported EBITDA

1,117

(900)

217

414.75%

Analysis of Accounting Errors on Reported Earnings per Share (EPS)

Earnings per share in Q1 2008 and Q2 2008 were materially overstated by a significant 23.53% and 17.86% respectively, since Overstock.com’s losses in each period were wider than originally reported.

More important, an accounting misstatement that "hides a failure to meet analysts' consensus expectations for the enterprise," is a red flag that runs afoul of SEC Staff Accounting Bulletin No. 99, governing materiality. Wall Street analysts' mean consensus expectations for EPS was -$0.28 for Q2 2008 (Source: Yahoo Finance).

Originally, Overstock.com's reported EPS equaled analysts' mean consensus expectations of -$0.28 EPS in Q2 2008. However, with an accounting error adjustment of $0.05 in added losses per share, Overstock.com failed to meet analysts' mean consensus expectations for EPS in Q2 2008 by $0.05 per share.

Analysis of Customer Refund and Credit Accounting Errors on Reported EBITDA

In Q1 2008, Overstock.com’s reported EBITDA was materially overstated by a significant 29.37%. In Q2 2008, Overstock.com’s reported EBITDA was materially overstated by a whopping 414.75% and the company's reported EBITDA was reduced from $1.117 million to a paltry $217K!

Now consider Overstock.com's EBITDA overstatements in conjunction with the company's acknowledgement in a letter (page 18) to the SEC about the importance of EBITDA as a measure of valuing the company:

A multiple of EBITDA is currently the most standard measure of valuation in the industry.

Note: Bold print and italics added by me.

Various analyst reports issued by Scott W. Devitt from Stifel Nicholas, Shawn C. Milne from Oppenheimer, and Justin Post from Merrill Lynch have valued Overstock.com in terms of multiples of EBITDA. Therefore, a material overstatement of reported EBITDA by Overstock.com results in a materially significant over-valuation of the company.

Perhaps that's why Overstock.com failed to disclose how its accounting errors materially overstated reported EBITDA. Worst yet, not a single Wall Street analyst attending the earnings call had the balls to ask management about how its accounting errors materially impacted their valuations based on EBITDA.

Overstock.com's Willful Non-compliance with SEC Regulation G and SEC Guidance Governing Non-GAAP Disclosures such as EBITDA Results in Even Greater Misstatements

In addition to Overstock.com's material overstatements of reported EBITDA from accounting errors, the company's financial reporting is further distorted by reporting a non-compliant EBITDA in violation of SEC Regulation G. Therefore, Overstock.com's restated EBITDA remains misstated, even after corrections for accounting errors.

As I detailed in my last blog post, Overstock.com improperly reconciles its non-compliant reported EBITDA to operating income or loss, rather than net income or loss (the most directly comparable GAAP measure required by Regulation G) and also improperly eliminates stock-based compensation costs from its reported EBITDA. Computations of Overstock.com's correct restated EBITDA in compliance with Regulation G are provided below:

EBITDA Computed in Compliance With Regulation G (In Thousands $)

Q1 2008

Q2 2008

Net income or (loss) as originally reported

(3.909)

(6,463)

Adjustments for accounting errors

(800)

(900)

Net income or (loss) restated

(4,709)

(7,363)

Interest income

901

888

Interest expense

(1,304)

(742)

Depreciation and amortization

6,497

5,887

EBITDA computed in compliance with Regulation G

1,385

(1,330)

EBITDA originally reported by Overstock.com

3,524

1,117

Percentage overstatement of EBITDA

154.4%

219.7%

In both Q1 and Q2 2008, Overstock.com’s non-compliant reported EBITDA, adjusting for both accounting errors and non-compliance with SEC Regulation G, was overstated by 154.4% and 219.7%, respectively. In addition, in Q2 2008, Overstock.com’s non-compliant reported EBITDA of positive $1.117 million flips to a negative EBITDA of $1.330 million, if EBITDA is reported in compliance with SEC Regulation G.

More important, Overstock.com's accounting errors and added misstatements from its willful non-compliance with SEC Regulation G is a red flag under SEC Staff Accounting Bulletin No. 99, governing materiality. The company's misstatement of Q2 2008 EBITDA "changes a loss to income and vice versa."

During the Q3 2008 earnings call, CEO Patrick Byrne bragged that Overstock.com reported its:

…third positive EBITDA in a row.

Byrne's comment is simply not true, since Overstock.com’ uses a non-compliant EBITDA in violation of Regulation G.

Since Overstock.com's Q2 2008 misstatement of EBITDA results in a non-compliant positive EBITDA, rather than a compliant negative EBITDA, it "masks a change in earnings or other trends," under SAB No. 99, because the company did not achieve positive EBITDA in three consecutive quarters.

In addition, Patrick Byrne's hyping a non-compliant reported EBITDA runs counter to his claimed principle of setting "a gold standard in communicating with candor" Overstock.com's results and choosing "principles at the conservative edge of GAAP…."

Overstock.com CEO Patrick Byrne's Flip Flops and Double-Talk about Why Overstock.com uses EBITDA

In April 2004, Patrick Byrne told CNBC, "I don’t believe in EBITDA. If somebody talks EBITDA, put your hand on your wallet; they’re a crook." In January 2006, Byrne told Business Week reporter Tom Mullaney that, "…I think “EBITDA” is the stupidest thing I ever heard emanate from Wall Street (no small feat)." Finally, in March 2006, he told Greg Sandoval from c/net news.com that EBITDA is a "phony accounting standard--pro forma."

During the Q3 2008 earnings call, Patrick Byrne's offered the following excuse for flip-flopping on EBITDA, despite his previous criticism of it, in response to questions raised by me in a previous blog post:

There are two times, as I've said a dozen times, I'm sure or more, that EBITDA is interesting. One is when you're in a low cash situation, it gets very interesting. Also just when you're in a situation of not having to do much CapEx, and our CapEx dropped significantly below our actual GAAP depreciation.

Note: Bold print and italics added by me.

As described below, Byrne’s claims about why he is now using EBITDA are contradicted by Overstock.com's recent financial performance.

Patrick Byrne has bragged that Overstock.com is not in a "low cash situation" with about $70 million in cash balances at the end of the latest quarter.

During Q3 2008, capital expenditures were much higher than the previous year's comparable quarter and capital expenditures were higher than GAAP depreciation, in contrast to Byrne's comments.

During Q3 2008, expenditures for property and equipment ("CapEx") totaled $8.8 million compared to $316K during Q3 2007 or about 27 times higher, in contrast to Byrne's comment claiming that EBITDA is "interesting" when capital expenditures are dropping.

In addition, during Q3 2008, Overstock.com's capital expenditures of $8.8 million exceeded depreciation and amortization expenses of $5.6 million by $3.2 million or 57%. This disclosure contradicts both Byrne's and the company's disclosure that using EBITDA is justified when capital expenditures are lower than depreciation expenses.

The Silence of the Wall Street Analyst Lambs

Not a single Wall Street analyst attending the earnings call, challenged Byrne's double-talk and no one asked a single question about the impact of Overstock.com's misstatements on their previous valuation models using EBITDA. Do Nat Schindler from Merrill Lynch, Dom Lacava from Canaccord Adams, and Scott Devitt from Stifel Nicolaus & Company really care about Overstock.com's accounting errors or have they traded their skepticism in return for coveted access to earnings calls? The silence of these Wall Street lambs is really pathetic.

To make matters worse, Overstock.com refused to let me asks questions during the earnings call. What are they afraid of?

Investigative reporter and best selling author Gary Weiss observed in his blog:

...the analysts on the call (the much-feared Antar having been excluded), timidly let all this bullcrap fly, unchallenged.

This convicted felon has warned warned Overstock.com's unprincipled management team that its bullcrap will not go unnoticed by me. I'll have more to say about Overstock.com's Q3 2008 earnings call in part 3.

Written by:

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

Disclosure: Not long or short Overstock.com and more transparent about my criminal past than Patrick Byrne is about his history of lies to investors.

Recommended reading in other blogs:

Zac Bissonnette

Joe Nocera

Tracy Coenen

1 comment:

john lichtenstein said...

You have to be really careful when you select a normalization factor. It's tricky to use a value that is sometimes positive and sometimes negative, and especially tricky to use a value that can be close to zero. So when you report earnings overstatement as a percentage of reported EBITDA, this is a really hard quantity to understand. What if the error was $10k, and the reported EBITDA was $1. Is this a 1000000% error?

Divide instead by gross margin, or even revenue.

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