Monday, March 05, 2012

Is Overstock.com in a Death Spiral?

Last Friday, Overstock.com (NASDAQ: OSTK) reported a fourth quarter net loss of $3.4 million compared to net income of $14.9 million in the previous year’s fourth quarter. Its revenues declined 10% to $314.1 million compared to $348.9 million in the previous year's fourth quarter. Details of the fourth quarter financial results were so bad, that Overstock.com did not present a full income statement for that quarter in its press release. Instead it only provided key metrics of its fourth quarter numbers and presented a full year income statement. For the entire year, Overstock.com reported a net loss of $19.4 million compared to net income of $13.9 million in the previous year. Its 2011 revenues decreased 3% to $1.054 billion compared to $1.090 billion in the previous year.

As of December 31, 2011, the company reported a net working capital deficit (current assets less current liabilities) of $14.1 million. Overstock.com's negative net working capital balance indicates that it’s having problems paying its bills as it entered into its traditionally weakest quarter of the year (the first quarter of 2012). Overstock.com common stock closed at $6.11 per share, down $0.77 per share as investors reacted to the company’s horrible earnings report.

Overstock.com inserted new language in its 2011 10-K report warning investors that, “We may not be able to achieve profitability on a quarterly or annual basis in the future.” In addition, the company warned that its poor financial performance could disrupt its relationships with suppliers concerned about getting paid.

Overstock.com will have to raise substantial amounts of new cash to pay its bills and avoid possible insolvency. The company's direct and indirect costs of raising new funds could be so onerous that the company and its current shareholders could be left in even worse financial straits. It's known as a "death spiral."

If the company raises equity, the amount of new funding required by it to stay afloat could significantly dilute the value of its existing common shares and send its stock price spiraling down even further. If Overstock.com tries to raise cash in the form of debt its interest rates could be much higher because of its deteriorating financial condition and the looming possibility of bankruptcy. Higher interest costs would increase future losses.

Overstock.com faces an ongoing investigation by the Securities and Exchange Commission after it was discovered that the company violated various accounting rules to inflate earnings in past years. District Attorney’s from seven California Counties are suing Overstock.com for alleged consumer fraud and are seeking over $15 million of restitution, fines, penalties, and cost reimbursements from the company. Last May, the Judge in that case had to compel Overstock.com to turn over information to the California District Attorneys after they complained to the court that it was illegally withholding subpoenaed documents. On December 28, 2011, The Huffington Post reported that a study found, “The site with the dubious honor of proffering the worst customer service in 2011 was Overstock.com, those ubiquitous merchants of discounted furniture, clothes and home furnishing.”

Suppliers concerned about getting paid

In its 2011 10-K report, Overstock.com warned investors that its suppliers may require it to prepay for its purchases and might suspend doing further business with the company due to its poor financial performance:

Financial performance concerns may cause fulfillment partners or other suppliers to limit or suspend doing business with us, or require prepayments.
We rely upon our fulfillment partners and other suppliers for the product offerings sold on our website and other products and services we use to run our business. Our ability to retain or attract new fulfillment partners and other suppliers may depend in part on our financial performance. Poor financial performance may create concern about our creditworthiness, which could result in suppliers choosing to limit or suspend doing business with us or require us to prepay for our purchases, which could harm our business, prospects, financial condition and results of operations. [Emphasis added.]

Overstock.com's inventory decreased $9.121 million to $22.993 million as of December 31, 2011 compared to $32.114 million in the previous year. Its accounts payable increased $3.021 to $70.332 million from $67.311 million in the previous year. When a company owes out more money to its suppliers despite a drop in inventory, it indicates that the company delayed payments to its suppliers. Overstock.com was able to temporarily spruce up its reported cash flows from operations and free cash flows by $12.142 million because it's taking a longer amount of time to pay its suppliers ($9.121 million from reduction of inventory plus $3.021 million increase in accounts payable). However, the window dressing of cash flow numbers is only temporary since it will have to pay those vendors during the first quarter of 2012. (Note: There is a $77,000 discrepancy between the increase in accounts payable on the balance sheet and the increase in accounts payable in the statement of cash flows.)

Is Overstock.com in a death spiral?

Patrick Byrne
Overstock.com could require approximately $50 million to cover its $14.1 million working capital deficit and provide a cushion to keep it afloat. As of February 10, 2012, there were 23.387 million shares of outstanding common stock. Since the company is expected to continue losing money in the next few quarters, it may have to raise all its funds in the form of equity instead of debt. With new equity instead of debt, the company won't have to pay potentially onerous interest costs and risk higher losses.

On Friday, Overstock.com common stock closed at $6.11 per share, down $0.77 per share. Based on Friday’s stock price, $50 million of new common equity would require Overstock.com to issue at least 8.183 million new common shares ($50 million new equity divided by $6.11 per share) which could dilute existing shareholders by 35% (23.387 million outstanding shares divided by 8.183 million new shares). A potential 35% dilution of existing shareholders stakes could send the stock spiraling below $5 per share and force Overstock.com to issue even more shares.

Many institutions will not own stock that is trading under $5 per share. If certain institutions sell their stock or other institutions cannot buy the stock due to that limitation, Overstock.com shares could spiral down even further. Most stocks cannot be margined under $5 per share and other investors may choose to avoid buying its shares if they cannot borrow against it.

Canadian fund manager Francis Chou takes a bath on Overstock.com investments

Francis Chou
One person who has taken a bath while trying to support Overstock.com's stock price is Canadian fund manager Francis Chou. From January 1, 2011 to January 6, 2012, Chou's funds purchased 1,041,029 Overstock.com thinly traded common shares as it dropped from $16.48 per share on December 31, 2010 to $6.99 per share on January 6, 2012. Chou's funds paid an average price of $10.63 per share.

At Overstock.com's closing stock price of $6.11 per share last Friday, Chou's funds are down $4.54 per share (26%) on its recent investments in common stock. To date, Chou's funds have invested approximately $57 million in the company’s common stock and own approximately 14% of all its outstanding common shares. Chou's total investment is losing over $35 million (over 60%).

Overstock.com CEO Patrick Byrne had better timing than Francis Chou. Back on May 20 to May 24, 2010, Byrne's 100% controlled High Plains Investments LLC dumped 140,000 common shares at an average price of $22.11 per share and collected over $3 million in proceeds.

Is Overstock.com CEO Patrick Byrne on his way out?

In the 2010 10-K report, Overstock.com stated that:

Our performance is substantially dependent on the continued services and on the performance of our senior management and other key personnel, including Patrick M. Byrne, our Chief Executive Officer. [Emphasis added.]

While, in the 2011 10-K report, Overstock.com stated that:

Our performance is substantially dependent on the continued services and on the performance of our senior management and other key personnel.

The 2011 10-K report omitted Byrne’s name. It could be a subtle hint that he could be on his way out. His leadership has been a liability to the company.

Lies to investors and accounting shenanigans

On December 11, 2001, Overstock.com CEO Patrick Byrne appeared on Fox News claimed, “We're profitable.” Brenda Buttner asked, "Your real honest-to-goodness profit, not pro forma?" Patrick Byrne responded, "None of that stuff." On March 1, 2002, Business 2.0 Magazine reporter Owen Thomas asked, "Are you profitable? Patrick Byrne responded, "Yes, that's real GAAP profit, not Amazon-bullshit-accounting profit."

On March 5, 2002, Overstock.com filed an S-1 registration statement in connection with its planned initial public offering. It contradicted Byrne’s claim to Fox News that his company was anywhere near “profitable.” At that time, the company lost money in each and every quarter since its inception. It lost $13.8 million in 2001 and lost $2.997 million in the quarter ended December 31, 2001. In February 2003, Overstock.com filed its 2002 10-K report. It contradicted Byrne claim to Business 2.0 that Overstock.com was profitable. Overstock.com reported a loss of $9.725 million in the quarter ended March 31, 2002.

When Patrick Byrne could no longer lie about Overstock.com’s profitability, he resorted to breaking accounting rules to create fictitious earnings.

Over the last several years, this blog has detailed various illegal accounting shenanigans used by Overstock.com to materially overstate its financial performance. From Q2 2007 to Q2 2008, the company used improper EBITDA calculations to materially inflate its pro forma earnings in violation of S.E.C. Regulation G. For example, in the quarter ended June 30, 2008 Overstock.com reported a positive $1.117 million EBITDA using an improper calculation instead of a negative $0.430 million EBITDA had it complied with Regulation G. From Q4 2008 to Q3 2009, the company violated Generally Accepted Accounting Principles (GAAP) and materially inflated its reported earnings. For example, in the quarter ended December 31, 2008, the company improperly reported a $1.014 million profit by violating GAAP instead of a $0.705 million loss.

In both cases I alerted the company by providing detailed information about its accounting irregularities. However, its CEO Patrick Byrne chose to retaliate against me rather than immediately correct its financial reports. For example, during various conference calls with investors he personally attacked me while claiming that his company was complaint with accounting rules. My accounting analysis was eventually proven correct by Overstock.com's later revisions of financial reports.

In September 2009, the Securities and Exchange Commission started an investigation of the company after I complained to the regulator. In March 2010, Overstock.com was forced to restate its financial reports to correct various GAAP violations initially identified in this blog. The S.E.C. investigation of Overstock.com is ongoing. In its recent 2011 10-K report, Overstock.com disclosed that, "...unfavorable resolution of this matter could materially affect our business, prospects, financial condition and results of operations."

In February 2011, Overstock.com was penalized by Google for cheating on its search engine optimization code to boost its search ranking and increase revenues. Overstock.com blamed Google for contributing to its drop in 2011 revenues. However, if the company did not cheat on its search engine optimization, it would have reported lower revenues in previous years and its revenues would not have dropped in the current year.

On December 6, 2011, a California Judge dismissed Overstock.com's long running litigation against Goldman Sachs (NYSE: GS). In its 2011 10-K report, Overstock.com disclosed that Goldman Sachs could, "...seek reimbursement from us of their allowable court costs."

Loan defaults, failure to make timely disclosures, and poor excuses

On December 27, 2011, Overstock.com paid U.S. Bank $20.329 million (including a $1.428 million prepayment penalty) to terminate a Master Lease Agreement (Sale-leaseback transaction) to avoid a default based on its dismal fourth quarter financial results. On January 6, 2012, Overstock.com filed an amended 8-K report informing investors of its decision to hold shareholder advisory votes on executive compensation every three years. The company failed to disclose that its amended 8-K report was filed late. Overstock.com’s failure to file a timely amended 8-K report caused its December 9, 2011 Form S-3 registration statement seeking badly needed capital to be rendered invalid. Its failure to file a timely 8-K report caused it to default on a $20 million credit facility from U.S. Bank.

However, the company did not notify investors of the loan default. Under S.E.C. rules, an “event of default” is required to be disclosed within four business days (8-K General Instructions and Item 2.04). Overstock.com improperly delayed disclosure of its failure to file timely reports with the S.E.C. and its loan default until February 17, 2012, a day after it resolved its default issues with U.S. Bank. The bank granted the company a waiver of default “effective as of September 30, 2011”, the same day that the amended 8-K report was supposed to be filed.

I asked Overstock.com to explain why it didn’t disclose that its amended 8-K report was filed late, why it delayed disclosing the credit facility default to investors for several weeks, what steps it was taking to handle its invalid S-3 registration statement.

Jonathan Johnson
During the Friday March 2, 2012 conference call with investors, company President Jonathan Johnson responded that it was not necessary to disclose that the January 6, 2012 amended 8-K filing was filed late because it was “obviously late.” However, company disclosures about the frequency of shareholder advisory votes are frequently filed using amended 8-K reports, so the fact that an amended 8-K report was filed does not imply that it was filed late. Nothing contained in the amended 8-K report made it “obvious” that it was filed late.

Jonathan Johnson also claimed that Overstock.com delayed informing investors of the default in its $20 million credit facility with U.S. Bank because:

…we determined it was not material, U.S. Bank agreed and quickly provided a waiver when we requested in that.

However, U.S. Bank did not “quickly” provide a waiver. The late amended 8-K report was filed on January 6, 2012. U.S. Bank did not grant a waiver of default stemming from the late filing until several weeks later on February 16, 2012. Until Overstock.com resolved its regulatory issues and U.S. Bank granted the waiver of default, the bank could have accelerated payment on the $17 million due under the credit facility.

The issue of materiality is determined when the loan default occurred, not weeks later when it was later resolved. It's possible that Overstock.com did not know about the default for several weeks after the late amended 8-K report was filed and U.S. Bank quickly granted the company a waiver of default after it was informed of the breach of loan covenants. However, any delay in notifying U.S. Bank of the default would indicate that Overstock.com has issues monitoring its compliance with loan covenants (a possible material weakness in internal controls).

Coincidently, a few hours after the Friday conference call, Overstock.com filed an 8-K report to inform investors that it provided the wrong phone number for them to listen to the audio replay of the call. I guess that Overstock.com thinks that a wrong telephone number is more important to disclose to investors than a default on a $20 million credit facility. In big or small matters, this company can't seem to do anything right.

Since Overstock.com's inception over a decade ago, the company has accumulated over $260 million in losses and restated its financial reports three times to correct violations of Generally Accepted Accounting Principles (GAAP). The company revised its financial reports numerous times to correct violations of S.E.C. disclosure rules. Despite Overstock.com's repeated violations of accounting and S.E.C rules and retaliation against its critics, the S.E.C. granted it a waiver and allowed it to be eligible to use a Form S-3 registration to raise new capital. If Overstock.com crashes and burns, the S.E.C. may explain to angry investors why it waived its rules to permit the company to issue more common stock and raise new capital.

Written by:

Sam E. Antar

Recent Interviews


March 5, 2011: Forbes - When Sam Antar Speaks, People Listen...and Speak Their Mind by Walter Pavlo

March 5, 2012: Trusted Professional - Reformed ‘Crazy Eddie’ fraudster reveals tricks of the trade by Chris Gaetano

March 3, 2012: Wall Street Journal - Psychos on Wall Street, by Al Lewis (Print Story and Video)

Other Overstock.com Coverage

March 5, 2012: William K. Wolfrum Chronicles - Rush Limbaugh and Overstock.com’s Patrick Byrne: Misogynists getting their due

Disclosure

I am a convicted felon and a former CPA. As the criminal CFO of Crazy Eddie, I helped my cousin Eddie Antar and other members of his family mastermind one of the largest securities frauds uncovered during the 1980's. I committed my crimes in cold-blood for fun and profit, and simply because I could. If it weren't for the heroic efforts of the FBI, SEC, Postal Inspector's Office, US Attorney's Office, and class action plaintiff's lawyers who investigated, prosecuted, and sued me, I would still be the criminal CFO of Crazy Eddie today.

There is a saying, "It takes one to know one." Today, I work very closely with the FBI, IRS, SEC, Justice Department, and other federal and state law enforcement agencies in training them to identify and catch white-collar criminals. Often, I refer cases to them as an independent whistleblower. I teach white-collar crime classes for various government entities, professional organizations, businesses, and colleges and universities. I do not seek or want forgiveness for my vicious crimes from my victims. My past sins are unforgivable.

I do not own any Overstock.com securities long or short.

3 comments:

Jr Deputy Accountant said...

Wow, this is unexpectedly realistic from Overstock... does Byrne see the end right before him?

mindfuck said...

Nice Analysis...We were a bit too late to the Overstock short party...but think you've done a great job with the analysis. Great work.

Shortzilla

Gilbert said...

Thanks for the work in covering this story. I've been on both sides of those O.co discounted curtains and I believe you're usually spot on. BTW, am I the only one that thinks Pres J Johnson sounds like he's smoked for 30+ years?

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