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. [Emphasis added.]

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.” 

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. [Emphasis 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. [Emphasis added.]

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. [Emphasis added.]

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. [Emphasis added.]

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. [Emphasis added.]

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. [Emphasis added.]

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. [Emphasis added.]

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…. [Emphasis added.]

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.

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. [Emphasis added.]

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. [Emphasis added.]

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.

Did Overstock.com CEO Patrick Byrne cook the company's numbers and mislead investors? (Part 3 - The end game)

Blog series: Did Overstock.com CEO Patrick Byrne cook the company's numbers and mislead investors?

In the first two parts, I detailed Overstock.com and its management's inconsistent, conflicting, contradictory, and deceitful disclosures in its financial reporting.

In part 1, I detailed how Patrick Byrne backtracked and used in his own words, a "a phony accounting standard--pro forma," the reduction of inventory reserves, and the reversal of previously booked nonrecurring expenses to hype up Overstock.com financial performance for the second quarter of fiscal year 2007. Without, the use of that "phony accounting standard--pro forma," Overstock.com's hyped up turn around would have all but disappeared. In addition, I detailed how the reduction in inventory reserves in the second quarter of fiscal year 2007, wiped away Overstock.com's entire improvement in operating income.

In part 2 of this series, I detailed the possible manipulation of earnings by Overstock.com using a technique, known as "managing earnings," that involves manipulating inventory reserves. I detailed how statements by Overstock.com about inventory and reserves are inconsistent and contradictory and as a result point to the possible manipulation of earnings.

In Part 3, we get to the end game. I discuss why Overstock.com's two inconsistent, conflicting, and contradictory stories cannot coexist. I ask Overstock.com, Patrick Byrne, the Board of Directors, and Clay Corbus and Joseph J. Tabacco Jr. (Audit Committee members) to respond to the questions and issues I have raised.

Before I get to the end game, let's review certain facts from my previous blog item

In the first quarter of fiscal year 2006, Patrick Byrne had a "game plan." He "knew that things were going to get very ugly" at Overstock.com. He knew that "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." Patrick Byrne waited almost an entire year to tell investors that he "knew things were going to get very ugly" and that "it was going to be in the form of dumping a bunch of inventory."

During fiscal year 2006, as Overstock.com's inventory levels, Patrick Byrne and Jason C. Lindsey repeatedly played down any concerns about the pending nightmare that awaited Overstock.com.

April 28, 2006: Earnings conference call for the first quarter of fiscal year 2006

With a disaster looming, Patrick Byrne played down concerns over junk inventory by claiming that they were over:

...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. [Emphasis added.]

 July 28, 2006: earnings conference call for the second quarter of fiscal year 2006

Obviously, Overstock.com did not "come out of it" since it still had more junk inventory to sell. Jason C. Lindsey had discussed the progress of Overstock.com's reduction of inventory levels:

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. [Emphasis added].

November 6, 2006: earnings conference call for the third quarter of fiscal year 2006

Obviously, Overstock.com was not "more than adequately reserved...so that there is no more drag on margins." Patrick Byrne sang a different tune about gross margins and gave a small indication 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. [Emphasis added.]

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.

Fourth quarter of fiscal year 2006 financial results

Financial results during the fourth quarter of fiscal year 2006 did get quite ugly, in fact very ugly. Revenue had dropped about 6% to $294 million from $315.0 million versus the comparable second quarter of fiscal year 2005. Gross profit margins dropped to 9.3% from 14.0% and net losses continued to grow to $45.6 million from $6.3 million.

During the fourth quarter of fiscal year 2006, as Overstock.com's gross inventories (before reserves) declined from about $73.3 million at the end of the third quarter to about $26.9 million, while inventory reserves rose from about $4.5 million to $6.6 million. The percentage of inventory reserves to gross inventory rose dramatically from 6.14% to 24.52%, or almost a 300% relative increase in reserves.

February 5, 2007: earnings conference call for the fourth quarter of fiscal year 2006

During the fourth quarter earnings conference call, Jason C. Lindsey, Overstock.com's Chief Operating Officer, made the following statements, relating to inventories and gross margins:

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. [Emphasis added.]

The end game

Let's examine some financial information.

During fiscal year 2006, Overstock.com had in fact dumped a bunch of inventory. 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. 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.

Now let's examine the results starting with the first full quarter after Patrick Byrne's undisclosed knowledge that things were going to get "very ugly." From the end of the first quarter of fiscal year 2006 to the last quarter of the fiscal year, Overstock.com's gross inventory (before reserves) dropped by 57.8 million from $84.7 million to about $26.9 million. Inventory reserves rose from about $3.3 million at the end of the first quarter to about $6.6 million at the end of the year. On a relative basis, inventory reserves went up a staggering 529% from about 3.9% of gross inventory at the beginning of the year to 24.5% of inventory at the end of the year.

So Overstock.com's inventory did indeed drop. However, despite the massive drop in inventories, it seems that no progress was made in reducing the level of junk inventory. On either a dollar value basis, or more accurately, on a relative percentage basis, the level of junk inventory had in fact increased.

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?

During the year Overstock.com had claimed that the drag on gross margins was a result of selling junk merchandise. At the end of the year, the company claimed that it was pleased with the significant progress it made in reducing junk inventory. If that is true, why was record inventory reserves booked at the end of the fiscal year? If those inventory reserves were accurate, how can their other statements be true?

Excessive inventory reserves in the fourth quarter of fiscal year 2006 would help Overstock.com produce improving financial results in fiscal year 2007. In addition, excessive inventory reserves in the fourth quarter would help Overstock.com cover-up misstatements of inventory reserves in previous quarters.

I have sent all three of my blog posts in this series to Patrick Byrne, Overstock.com's Board of Directors, and separately to Clay Corbus and Joseph J. Tabacco Jr (Audit Committee members). I have asked them to respond to the questions and issues that I have raised. In addition, the Securities and Exchange Commission was Cc'd on the email.

I await their answers.

The ball is in their court.

Written by,

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

Other blogs covering this issue:

September 1, 2007: Mar's Everything - Lies everywhere by Mar

August 27, 2007: Tracy Coenen - Overstock.com cooking the books?

August 27, 2007: Gary Weiss - Patrick Byrne Goes Speechless over Managed Earnings

Did Overstock.com CEO Patrick Byrne cook the company's numbers and mislead investors? (Part 2)

At my very first accounting class at Bernard M. Baruch College, I was taught by the great distinguished Professor Abraham Briloff, that "accounting is the language of business." Professor Briloff saw CPAs as the guardians of capitalism against the cancer of white collar crime. However, as Crazy Eddie's paid for my education and gave me a full time salary off the books as I attended college, my goal was to be part of the brutal cancer of white collar crime that infects our great capitalist system.

White collar crime is a crime of persuasion. Often, the white collar criminal uses "the language of business" to persuade investors to buy their company's stock at an inflated values. At college, we had many debates about the essence of accounting. Is accounting an art or a science? For the white collar criminal, there is no debate: accounting is a work of art to be crafted.

Patrick Byrne's continued hyping of Overstock.com and deceit by using "the language of business" as an instrument of persuasion is nothing new. His deceptions follow the same pattern, time and time again: accentuate the positive, deflect from the negative, and minimize any concerns, and then raise capital to finance his money losing machine.

In part 1 of my series of blog posts entitled, "Did Overstock.com CEO Patrick Byrne cook the company's numbers and mislead investors?" I detailed how Patrick Byrne backtracked and used in his own words, a "a phony accounting standard--pro forma," the reduction of inventory reserves, and the reversal of previously booked nonrecurring expenses to hype up Overstock.com financial performance for the second quarter of fiscal year 2007. Without, the use of that "phony accounting standard--pro forma," Overstock.com's hyped up turn around would have all but disappeared. In addition, I detailed how the reduction in inventory reserves in the second quarter of fiscal year 2007, wiped away Overstock.com's entire improvement in operating income.

In part 2 of this series, I will detail the possible manipulation of earnings by Overstock.com using a technique, known as "managing earnings," that involves manipulating inventory reserves. I will detail how statements by Overstock.com about inventory and reserves are inconsistent and contradictory and as a result point to the possible manipulation of earnings.

Patrick Byrne had an unrevealed game plan in the first quarter of fiscal year 2006

Sometime during the first quarter of fiscal year 2006, Patrick Byrne knew that things would be really ugly at Overstock.com. He had a game plan to handle the crises. However, he kept things quiet until about a year later. Then, on April 25, 2007, during the first quarter fiscal year 2007 earnings conference call, Patrick Byrne would make the following startling admission:

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. [Emphasis added.]

Instead of coming clean with investors, Patrick Byrne was too busy hyping the future prospects of Overstock.com. For example, on March 1, 2006, appearing on CNBC, Patrick Byrne sounded optimistic about Overstock.com's prospects for the balance of the 2006 fiscal year as he made the following comments:

Our cash is just fine.

We'll be able to make it through this year comfortably.

Through the year we should have a nice positive cash flow.

We should be EBITDA positive this year.

Five days later, on March 6, 2006, Patrick Byrne was interviewed by Greg Sandoval for an article entitled "Newsmaker: CEO in the Hot Seat" published by 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.

Patrick Byrne's performance has not matched his hype

Hyping Overstock.com's financial prospects only to later disappoint investors is nothing new for Patrick Byrne. Overstock.com's revenue for fiscal year 2006 ended up about $200 million short, at about $796 million. Its EBITDA ended up way off the mark too, at around negative $65 million. There was no "nice positive cash flow" for Overstock.com in fiscal year 2006 as operating cash flow ended the year at about negative $26 million. Overstock.com required cash infusions of over $50 million from two equity offerings during the year, so it "it not make it through" the year "comfortably."

First Quarter of Fiscal Year 2006

Despite Patrick Byrne's previous claims on CNBC and c/net news that Overstock.com would be "EBITDA positive" better in 2006, the company reported dismal results in the first quarter of the 2006 fiscal year. While revenue had increased about 9% to $180.2 million from $165.9 million versus the comparable first quarter of fiscal year 2005. Gross profit margins dropped to 14% from 14.9% and net losses more than tripled to $15.9 million from $4.3 million.

On April 28, 2006, during the first quarter earnings conference call, Doug Anmuth, from Lehman Brothers asked Patrick Byrne about his previous statements about achieving positive EBITDA:

...you gave a pretty rough outlook in terms of your claim that you could do break-even or better EBITDA and operating cash flow for the year. Do those numbers still hold?

Despite the fact that losses tripled in the first quarter, meaning that Overstock.com would have to make up a lot of lost ground to achieve "break-even or better EBITDA and operating cash flow" for the entire year, Patrick Byrne still claimed EBITDA would be break even or better:

As far as break-even on an EBITDA basis, definitely. It would be hard for us to break even on a GAAP basis, but with $35 million of depreciation and amortization, having that back into the -- I would imagine yes, we should break even or better. [Emphasis added.]

With massive losses in the first quarter and the knowledge that that "things were going to get really ugly and that the company was going to have to take medicine...in the form of dumping a bunch of inventory" how could Patrick Byrne still claim that Overstock.com would "definitely" end up the year at "break even or better" on an EBITDA basis?

Was it a delusional fantasy, hype, or plain old stupidity?

Gross inventories (before reserves) declined from about $98.5 million at the end of the fourth quarter of fiscal year 2005 to about $84.7 million at the end of the first quarter of fiscal year 2006. Inventory reserves dropped during the first quarter from about 5.32% of gross inventory to about 3.90%, for about a 27% reduction in relative reserves. Overstock.com's reduction in inventory reserves added about a full percent to gross margins. Had there not been a reduction in such reserves, Overstock.com's gross margin decline from 2006 to 2005 would have doubled from about 0.9% to 1.9%.

During the conference call, Overstock.com's management remained silent about the material impact of the reduction of reserves on gross margins.

Patrick Byrne hyped Overstock.com's future gross margin prospects by appearing optimistic, claiming that such gross margins would improve by at least 2% to 3% after a stable second quarter:

Our gross margin I think is going to be stable for the second quarter, as we keep making these changes, but I gave you the reasons why I think there's 200 or 300 basis points. I ultimately think this is a 17% or 18% gross margin business, and I think we can get there in the near future. In the fourth quarter, certainly a number around 17%. [Emphasis added.]

Like the billion dollars in annual revenue that never happened, the positive EBITDA that was never achieved, none of Patrick Byrne's hyped up guidance on future gross margins for 2006 were ever achieved, too. They declined dismally during the remainder of the fiscal year.

Patrick Byrne went on to claim how sophisticated Overstock.com systems were in monitoring Overstock.com's inventories and squeezing out every last dollar of profit:

One of the first things that they have done that's been very powerful is they let us do much more sophisticated inventory analysis, and we just really think we should be able to squeeze a lot out of our inventory. [Emphasis added.]

Therefore, Patrick Byrne had the knowledge and the means to understand the extent of Overstock.com's substantial inventory problems but instead let inventory reserves drop in the first quarter.

Patrick Byrne was questioned about a 3% drop in gross margins on its direct revenue category compared with the previous year:

Scott Devitt - Stifel Nicolaus: Just a follow-up on the direct gross margin. It was down 300 basis points, and I think, Patrick, in the letter you noted warehouse costs as being one explanation. I'm wondering, because the inventory level was high coming out of 4Q, what component of that was pricing just to drain inventory levels as well.

Patrick Byrne: There's definitely a piece of that in the first quarter, and there will be a piece of that in the first part of the second quarter, although 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. [Emphasis added.]

Did Overstock.com really "come out of it now" and was the junk inventory flushed out?

It seemed from Overstock.com's large reduction of inventory reserves, that some of its junk inventory was flushed out. However, inventory reserve levels as a percentage of gross inventories were still 50% higher than in the previous fiscal year's quarter (about 3.90% vs. 2.59%). Despite, Patrick Byrne's statement claiming "we've come out of it now" it seemed the Overstock.com had more inventory to flush out than he led everyone to believe. Inventory reserve levels were higher compared to last year's quarter. In addition, he did not share with anyone yet that "things were going to get really ugly and the company was going to have to take medicine...in the form of dumping a bunch of inventory."

Armed with the knowledge that things were going to get "really ugly" regarding Overstock.com's inventories and "very powerful" systems that permitted "much more sophisticated" analysis, we have to ask why did Overstock.com reduce its inventory reserves in the first quarter knowing it had to "dump a bunch of inventory?"

Apparently, Patrick Byrne was trying to hype up Overstock.com's prospects by still claiming that EBITDA would be break-even or positive. The reduction in inventory reserves cut in half the decrease in gross margins during the quarter.

Was Patrick Byrne attempting to play down concerns over inventory and gross margins?

Did Overstock.com need a cash infusion despite Patrick Byrne's claim on CNC about 7 weeks earlier that the company will "be able to make it through this year comfortably" and that it should have a "nice positive" cash flow?

During the first quarter earnings conference call, David Chidester discussed cash flows:

...operating cash flows during the quarter were an outflow of $73 million and free cash flows were an outflow of $80 million. [Emphasis added]

Obviously, Overstock.com was bleeding cash fast despite Patrick Byrne's statements on CNBC on March 1, 2006 that:

Our cash is just fine.

We'll be able to make it through this year comfortably.

Through the year we should have a nice positive cash flow. [Emphasis added.]

During the earnings conference call, Patrick Byrne attempted to play down the issue of burning cash flows:

Liquidity -- I know folks are talking about liquidity. I don’t see -- I’m always more comfortable doing barrel rolls close to the ground than my passengers. I don’t see us as having liquidity crises.

Just days later, on May 3, 2007, Overstock.com got a badly needed cash infusion $25 million, despite Patrick Byrne's previous comments. Overstock.com's Prospectus Supplement stated under the "Use of Proceeds" section:

Unless otherwise indicated in any prospectus supplement, the net proceeds from the sale of securities offered by this prospectus will be used for general corporate purposes and working capital, including sales and marketing activities and inventory purchases. In addition, we may use a portion of the net proceeds to acquire complementary technologies or businesses. However, we currently have no commitments or agreements and are not involved in any negotiations with respect to any such transactions [Emphasis added.]

Delays in disclosures followed by later admissions is nothing new for Patrick Byrne


On May 9, 2006, the Securities and Exchange Commission began a formal investigation of Overstock.com. While Patrick Byrne belatedly revealed on August 12, 2005 that an informal SEC inquiry had begun months earlier in February 2005, Overstock.com made no mention of the informal inquiry in its reports filed with the SEC. After the formal investigation by the SEC was disclosed, Overstock.com 's pending infusion of about $16 million in stock equity was canceled.

On May 17, 2006, Patrick Byrne received a personal subpoena from the SEC as part of its probe of Overstock.com. It was not until almost an entire year later, that Overstock.com finally disclosed Byrne's personal subpoena from the SEC in its 10-Q that was released on May 9, 2007. Months later, on August 10, 2007, after previous denials that an embittered Patrick Byrne finally revealed that he is the target of an ongoing investigation by the Securities and Exchange Commission and claimed that high level government employees at the SEC were corrupt.

Second Quarter of Fiscal Year 2006

Despite Patrick Byrne's previous claims on March 1 on CNBC, on March 6 in c/net news, and on April 28 that Overstock.com would be "EBITDA positive" or better in 2006, the company reported worsening results in the second quarter of fiscal year 2006.

With the filing of Overstock.com's 10-Q for the second quarter, it became apparent how Overstock.com's dismal cash flow situation was worsening despite Patrick Byrne's comment during the first quarter earnings conference call on April 28, 2006 saying, "I don’t see us as having liquidity crises." On June 30, 2006 Overstock.com's cash balance dropped to $45.7 million from $51.8 million on March 31, 2006 despite receiving a cash infusion of $25 million from selling common stock on May 3, 2006.

Operating cash flow for the quarter was negative $6.2 million and free cash flow was negative $12 million.

While revenue had increased about 6% to $160.0 million from $150.6 million versus the comparable second quarter of fiscal year 2005. Gross profit margins dropped to 14.4% from 15.1% and net losses increased to a staggering $15.8 million from $2.0 million.

However, during the previous first quarter conference call Patrick Byrne had claimed:

Our gross margin I think is going to be stable for the second quarter.... [Emphasis added.]

Patrick Byrne's previous claim that gross margins would be "stable for the second quarter" is contradicted by admission about a year later, on April 28, 2007, that he had a "game plan" in the first quarter. He "knew things were going to get really ugly" and that the company was going to have take medicine...the form of dumping a bunch of inventory."

Gross inventories (before reserves) declined from about $84.7 million at the end of the first quarter of fiscal year 2006 to about $78.2 million at the end of the second quarter. However, inventory reserves rose during the second quarter from about 3.90% of gross inventory to about 4.35%, for almost a 12% increase in relative reserves.

Previously, Patrick Byrne had claimed during the first quarter earnings conference call that Overstock.com's inventory issues were over despite his undisclosed plan the "dump" inventory at very low prices:

...we've come out of it now, but we did mark things down in order to flush things through.

Now, in the second quarter, inventory reserves increased about 11% on a relative basis. We need to ask, did Overstock.com begin at that time a gradual bump up reserves again to regain lost ground from previously understating inventory reserves?

Was the bump up in inventory reserves a reaction to the SEC formal investigation of Overstock.com that began on May 9, 2006? The SEC had subpoenaed a broad range of documents about Overstock.com's financial disclosures and accounting policies.

Patrick Byrne knew that things were "ugly" and had a plan to "dump" inventories. He had claimed that Overstock.com was finished with its inventory problems in the first quarter. Now, Patrick Byrne apparently needed to make up for previous understatements of inventory reserves. After all, Overstock.com had already raised new equity and the SEC closing was focusing on Byrne.

During the second quarter fiscal year 2006, earnings conference call, Jason C. Lindsey assured investors that inventory was "more than adequately reserved" and that as a result there will be "no more drag on margins":

You have seen there is a drag on margins in the first and second quarter from selling this stuff. 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. [Emphasis added.]

However, despite Jason C. Lindsey's statement (above) that "we are more than adequately reserved...so that there is no more drag on margins," during the next two quarters of fiscal year 2006, Overstock.com's gross margins markedly declined as inventory reserves significantly increased.

Third Quarter of Fiscal Year 2006

During the third quarter of fiscal year 2006, revenues dropped about 6% to $158.7 million from $169.3 million versus the comparable third quarter of fiscal year 2006. Gross profit margins declined to 14.5% from 15.7%.

However, in the previous second quarter conference call, Jason C. Lindsey had claimed:

...there is no more drag on margins....

Gross inventories (before reserves) declined from about $78.2 million at the end of the second quarter of fiscal year 2006 to about $73.3 at the end of the third quarter. However, inventory reserves rose during the third quarter from about 4.35% of gross inventory to about 6.14%, for almost a 41% increase in relative reserves.

However, in the previous second quarter conference call, Jason C. Lindsey had claimed:

...obviously, we are more than adequately reserved...

On November 6, 2006, during the third quarter earnings conference call Patrick Byrne sang a different tune about gross margins. Discussing the declining trend of gross margins on at Overstock.com, Patrick Byrne stated:

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. [Emphasis added.]

Later, during the third quarter earnings conference call, there was the following question and answer:

Frank Gristina - Avondale Partners: What kind of margins when you are liquidating are you getting...?

Jason C. Lindsey - Unfortunately, they are kind of all over the board. 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.

With "$10 million to $20 million" in junk inventory needing to be liquidated, Jason C. Lindsey was obviously playing down the extent of losses by balancing the negative and the positive. He said:

Some of the stuff is negative and some of the stuff is fairly profitable. We just do not want to be in that category anymore for a lot of reasons. [Emphasis added.]

Despite the talk of reduced gross margins during the third quarter earnings conference call, there was no discussion as to the adequacy of inventory reserve levels despite Lindsay's statements in the previous quarter's conference call that Overstock.com's inventories were "more than adequately reserved."

During next quarter, not only would gross margins dramatically decline, but there would be an almost four-fold increase in relative inventory reserves.

With the third quarter conference call disclosure that Overstock.com was "giving great deals and clearing a whole bunch of stuff out" we need to ask, did management realistically value its inventory at the end of the third quarter at the lower of cost or market as required under GAAP?

Did Overstock.com understate its inventory reserves and overstate inventories at the end of the third quarter of fiscal year 2006? Did Overstock.com purposely delay taking reserves on its inventory until after it received a cash infusion by raising new equity?

Net losses for the third quarter about doubled to $24.5 million from $12.4 million from the previous year's quarter.

While net cash from operating activities was a paltry $806 thousand, free cash flow was negative $7 million. Overstock.com's cash balance continued to drop from $45.7 on June 30, 2006 to $39.4 million.

On November 6, 2006, Overstock.com's third quarter press release, Patrick Byrne claimed:

We experience our annual cash nadir in early November, and then see a steady inflow of cash through the remainder of Q4.

Despite, Patrick Byrne's comments in the press release, about five weeks later, on December 15, 2006, Overstock.com raised over $35 million in new equity in a common stock offering.

Fourth Quarter of Fiscal Year 2006

The fourth quarter of fiscal year 2006 was a nightmare for Overstock.com. Revenue had dropped about 6% to $294 million from $315.0 million versus the comparable second quarter of fiscal year 2005. Gross profit margins dropped to 9.3% from 14.0% and net losses continued to grow to $45.6 million from $6.3 million.

However, during the previous second quarter conference call, Patrick Byrne had claimed:

I ultimately think this is a 17% or 18% gross margin business, and I think we can get there in the near future. In the fourth quarter, certainly a number around 17%. [Emphasis added.]

However, despite Patrick Byrne's claim that gross margins during the fourth quarter of 2006 would "certainly" be around 17%, it ended up at 9.3%.

For the entire fiscal year, sales ended at $796.4 million (before certain adjustments were made after the press release was issued in the 10-K), far short of the $1 billion and more in revenues touted by Byrne on March 6 and April 28, 2006. EBITDA for the fiscal year ended up at around negative $65 million, far below the "break-even" or better amount previously hyped by Byrne.

During the fourth quarter of fiscal year 2006, as Overstock.com's gross inventories (before reserves) declined from about $73.3 million at the end of the third quarter to about $26.9 million, while inventory reserves rose from about $4.5 million to $6.585 million. The percentage of inventory reserves to gross inventory rose dramatically from 6.14% to 24.52%, or almost a 300% relative increase in reserves.

During the fourth quarter earnings conference call, Jason C. Lindsey, Overstock.com's Chief Operating Officer, made the following statements, relating to inventories and gross margins:

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. [Emphasis added.]

During the previous quarter's conference call, Jason C. Lindsey had claimed that there was "$10 million to $20 million worth of stuff in our warehouse now that we do not ever want to have in our warehouse again" and that Overstock.com was "clearing it out nicely." Now he claimed that they sold the crap.

Later, in its 10-K report released for the fiscal year ended December 31, 2006, Overstock.com elaborated further:

We consciously and aggressively discounted older inventory during the fourth quarter, and as a result, our direct gross margins were negatively impacted. However, we did this to significantly clean and reduce our inventory in an effort to reduce the overall SKU (stock keeping unit) count on our website and to refine our product selection to categories that turn faster and have higher profitability. [Emphasis added.]

If the crappiest inventory was not around at the end of the fourth quarter, we would have to ask, why did Overstock.com book huge inventory reserves after claiming to have dumped their crappiest inventory?

Was Overstock.com possibly overstating inventory reserves at the end of the fourth quarter after understating such reserves at the end of the third quarter? Could it be that Overstock.com took advantage of an already catastrophic quarter to book added inventory reserves? By booking excess inventory reserves in the fourth quarter, it could increase future gross margins.

During the fourth quarter conference call, Jason C. Lindsey had claimed that Overstock.com had gotten "rid of all the slow-moving inventory" and "sold it" during the fourth quarter. If so, why were inventory reserves at all time highs?

For the fourth quarter of fiscal year 2006, Overstock.com reported negative gross margins of about $3.6 million on its direct revenues while gross margins dropped on its fulfillment partner revenues. My calculations indicate that Overstock.com lost about $7 million from liquidating about $40 million in inventory during the fourth quarter. If only "$10 million to $20 million" of the liquidated inventories were considered junk, as claimed by Lindsey in the previous quarter, Overstock.com would have taken even greater dollar losses on its liquidated inventory.

Did Overstock.com appropriately value its inventory at the lower of cost or market value at the end of the previous third quarter?

Did Overstock.com delay the recognition of possible additional required inventory reserves until after it raised new equity in its common stock offering on December 15, 2006?

In addition, on December 31, 2006, Overstock.com took charges of about $5.7 million for restructuring expenses and about $6.9 million for losses from discontinued operations.

The company was experiencing massive losses and increased negative cash flows going into the fourth quarter.

April 25, 2007: First Quarter Fiscal Year 2007 Conference Call

Patrick Byrne finally admitted that as of the first quarter of the previous fiscal year, he had a "game plan...of what was going to have to happen." He knew things were going to get really ugly and the company was going to have take medicine... in the form of dumping a bunch of inventory."

Let's analyze pattern of Overstock.com's inventory reserves.

At the end of the last quarter of fiscal year 2005, inventory reserves were about 5.32%. At the end of the first quarter of fiscal year 2006, inventory reserves dropped to 3.90% of gross inventory. By the end of the second quarter of fiscal year 2006, inventory reserves grew gradually to about 4.35% of gross inventory. For the third quarter of fiscal year 2006, inventory reserves grew to about 6.14% of gross inventory and in the last quarter of fiscal year 2006 inventory reserves massively grew to about 24.5% of gross inventory.


Considering the growth of inventory reserves relative to gross inventory during fiscal year 2006, it seems based on Patrick Byrne's statement (above) that Overstock.com took its sweet time to increase inventory reserves to appropriate levels.

During the first quarter fiscal year 2007 earnings conference call, Jason C. Lindsey continued to explain the liquidation of Overstock.com's crappiest inventory for the previous fiscal year's fourth quarter:

....another dynamic that is going on is as we liquidated all of our slow-moving inventory and things that did not meet our metrics last year, we really sold everything and got our inventory extremely fresh. [Emphasis added.]

The reasonable question remains that if Overstock.com liquidated all of its "slow-moving inventory" during the fourth quarter of fiscal year 2006 as stated above by Jason C. Lindsey, why was there a need for an inventory reserve of about 24.5% of gross inventory?

In addition, during the previous fourth quarter earnings conference call quarter earnings conference call, Jason C. Lindsey had also claimed that:

...we used the fourth quarter to get rid of all the slow-moving inventory.

However, later in the first quarter conference call, Jason C. Lindsey, backtracked and contradicted his earlier statement that Overstock.com "liquidated all our slower moving inventory...we really sold everything" by saying:

Now, one thing that we didn't sell was kind of all of our spring garden patio type of stuff....

So we do still have several million dollars worth of stuff that we call our excess inventory from last year that we didn't liquidate that we are going to be liquidating now and even into the beginning of the third quarter. Although we reserved against that and do feel like we have an adequate reserve and that we will be forced to -- and we will release that reserve some as we sell that stuff. I am just not sure exactly the clearing price of all that. [Emphasis added.]

Hey, remember what Jason C. Lindsey said previously on July 28, 2006 about adequate inventory reserves? Overstock.com later booked huge increases in inventory reserve amounts in the next three quarters. Do you trust Mr. Lindsey's reserve estimates?

Patrick Byrne would elaborate further:

But the one set of things he didn't do was the millions of dollars of that furniture, wrought-iron furniture, you can't sell it at Christmas. But we do have -- a big chunk of our inventory is still that and when that disappears over the next two months, three months, that is a significant chunk of our inventory and Jason has taken a very healthy reserve against all of that inventory. [Emphasis added.] 

I note that Jason C. Lindsey in previously describing (above) the previous third quarter fiscal year 2006 results had claimed that:

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.

 At the end of the third quarter of fiscal year 2006, with gross inventory at about $73.3 million (before reserves), Overstock.com's inventory reserves were about $4.5 million or about 6.1% of gross inventory. As stated above, Jason C. Lindsey claimed that there was "$10 to $20 million worth" of excess inventory at the end of the third quarter for fiscal year 2006.

Now, at the end of the first quarter of fiscal year 2007, with "several million in worth of...excess inventory," (which would seem to imply less excess inventory than at the third quarter of fiscal year 2006), Overstock.com had gross inventory (before reserves) of about $23.2 million and inventory reserves of $6.5 million or about 28.1% of gross inventory.

Therefore, with apparently less junk inventory in first quarter of fiscal year 2007, Overstock.com had booked over 350% more relative reserves than the previous third quarter of fiscal year 2006. After all, Patrick Byrne was now claiming to have "very healthy" inventory reserves.

So, I ask you: Is Overstock.com engaged in a practice known as "earnings management" by manipulating its inventory reserves?

Did Patrick Byrne hype Overstock.com's prospects like a penny stock promoter?

If Overstock.com did not engage in any malfeasance, is Patrick Byrne an incompetent CEO with delusional fantasies about Overstock.com's future financial performance?

Is Patrick Byrne just an out and out liar?

Part 3 of my blog series, "Did Overstock.com CEO Patrick Byrne cook the company's numbers and mislead investors?" coming soon.

Written by:

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

Other blogs covering this issue:

Tracy Coenen: Earnings management at Overstock.com?

Gary Weiss: Did Overstock.com Cook the Books?

Did Overstock.com CEO Patrick Byrne cook the company's numbers and mislead investors? (Part 1)

Part 1:

As a cold blooded, heartless, ruthless, and soulless career criminal during my Crazy Eddie days, I learned to always accentuate the positive and deflect from the negative in my dealings with Wall Street. I hardly ever faced an effective questioner whether the person was a Wall Street analyst, investment banker, or auditor. Rarely was I asked good follow up questions.

During Overstock.com's recent earnings conference call for the second quarter of fiscal year 2007, Overstock.com's management gave a hyped up explanation of the company's so-called turnaround. The representations of Overstock.com's management went unchallenged and important questions were not asked. I guess that not much has changed since my criminal days at Crazy Eddie.

As I listened to Patrick Byrne's delusional rants during the conference call, I was reminded of the movie, "The Silence of the Lambs." Well, Patrick Byrne frequently uses the alias Hannibal on internet message boards. His silent lambs were the Wall Street analysts that attended the earnings (or rather lack of earnings) conference call.

As investigative reporter and blogger Gary Weiss noted, during the conference call, Patrick Byrne was so bored that he posted a message on InvestorVillage thanking his antisocialmedia.net smear web site contributor, Overstock.com shareholder, and proud corporate shill, Evren Karpak.

After the conference call, the Overstock.com spin machine, led, Evren Karpak, rallied the troops on internet message boards, posted glowing assessments of the company, and roundly smeared Byrne's perceived enemies. Judd Bagley, the cyberstalking Director of Communications at Overstock.com and administrator of its antisocialmedia.net smear web site, recommended various stock pumping posts by Evren Karpak, on the InvestorVillage message board, using his alias De Daumier-Smith. Here is a link to posts on InvestorVillage that were recommended by Judd Bagley.

The day before the conference call, Overstock.com's (OSTK) stock closed at $17.61 per share. In the days that followed, the stock climbed above $20 per share.

Patrick Byrne claims turnaround in second quarter of fiscal year 2007 and cites non-GAAP "adjusted" EBITDA

Patrick Byrne, who recently and belatedly admitted to being a target of a continuing Securities and Exchange Commission probe into his activities and Overstock.com, has claimed that company's financial performance has markedly turned around in its most recent quarter. Recently, in Form 8-K filed with the Securities and Exchange Commission, Patrick Byrne claimed:

During Q2 we generated $14.9 million positive operating cash flow and $2.0 million positive EBITDA, excluding restructuring costs ("EBITDA excluding restructuring costs" is a non-GAAP number: see the reconciliation to operating income in the "Key financial and operating metrics" section below). Additionally, we generated $9.4 million positive trailing 12-month ("TTM") operating cash flow. Our Q2 gross margins of 17.7% were a historical best for us. At this year's start I suggested keeping an eye on contribution metrics (gross profits minus sales and marketing expenses): in Q2 our contribution margin was 12.3% (another record for us), and contribution profit grew 76% versus Q2 2006. [Emphasis added.]

Let's carefully examine the disclosures in Overstock.com's recent 10-Q filed after the conference call

A close examination of Overstock.com's financial disclosures paints a starkly different picture than Patrick Byrne's hyped up improvement of Overstock.com's financial results.

Overstock.com's recent 10-Q for the second quarter ended June 30, 2007 presented the following table in computing EBITDA and its non-GAAP adjusted EBITDA (click on image to enlarge):

Consider the effects of changes in inventory reserves

According to Overstock.com's 10-Q:

We write down our inventory for estimated obsolescence or damage equal to the difference between the cost of inventory and the estimated market value based upon assumptions about future demand and market conditions. If actual market conditions are less favorable than those projected by management, additional inventory write-downs may be required. Once established, the original cost of the inventory less the related inventory reserve represents the new cost basis of such products. Reversal of these reserves is recognized only when the related inventory has been sold or scrapped. [Emphasis added.]

Therefore, adjustments made under Generally Accepted Accounting Principles to reduce inventory values below cost to market value in prior periods have the effect of increasing gross margins in future periods. While a company properly follows GAAP by taking immediate write-downs of reduced inventory values, the side effect is that margins in future periods are increased as the junk inventory is sold.

In other words, by recognizing your inventory screw ups immediately under GAAP, you increase your profits in future periods.

Let's review the following simplified example:

In the first quarter, a company buys merchandise for $120, its books and records will reflect $120 of inventory.

In the second quarter, the company, under GAAP, reduces the value of its merchandise by increasing inventory reserves by $50 to reflect diminished future demand and market conditions. Therefore, in the second quarter, the company reduces its gross margins by $50. The net inventory book value on its balance sheet is reduced to $70 (original cost $120 less $50 inventory reserves).

In the third quarter, the company sells the merchandise for $90. Since the net value book value of the merchandise was previously reduced to $70, (as a result of taking a $50 reserve against its original purchase price of $120 in a previous quarter), the company recognizes gross margins of $20 (Sales $90 minus net book value $70).

The company, under GAAP, had gross margins of $20 in third quarter after selling the previously written down inventory. It would seem on its face to be an improvement over the reduction of gross margins by $50 in the second quarter resulting from the inventory write down. However, in reality the company lost $30 on its merchandise. The original cost of the merchandise was $120 and they sold it for $90.

Therefore, taking inventory reserves increases future gross margins. Increased future gross margins resulting from taking inventory reserves in previous periods does not necessarily reflect an underlying improvement in economic performance. As a company sells such inventory in future accounting periods, it simply reduces inventory reserves taken in previous accounting periods and recognizes additional gross margins.

At the end of Overstock.com's first quarter of fiscal year 2007, inventory reserves totaled about $6.5 million or a whopping 28.1% of the gross inventory of about $23.2 million. Had that entire inventory from the first quarter been liquidated during the second quarter at its original cost basis, Overstock.com would have had record gross margins of 28.1% or $6.5 million before certain allocations to cost of goods sold.

In the second quarter of fiscal year 2007, Overstock.com’s gross inventory (before reserves) dropped from about $23.2 million at the end of the first quarter to about $19.2 million at the end of the second quarter. There was a sizable drop in inventory reserves from about $6.5 million at the beginning of the quarter to about $3.8 million at the end of the quarter. The percentage of inventory reserves to gross inventory declined from about 28.1% to about 19.8%, a level still significantly above every period prior to the last quarter of fiscal year 2006.

Despite Overstock.com's massive increases in inventory reserves in previous quarters and now a substantial reduction of those reserves during the current quarter, no one asked any questions about the impact of the company's reduction of inventory reserves on gross margins, operating losses, and EBITDA. Overstock.com was not volunteering any information.

Overstock.com played up the improvement in its gross margins as signs of a major turn around without explaining the effects of its reduction of inventory reserves on increased gross margins, reduced operating losses, and improved EBITDA.

In fact, Overstock.com's reduction of inventory reserves in the second quarter was about $2.7 million. The company's operating losses dropped by about $2 million from the same quarter of the previous fiscal year. Therefore, Overstock.com's entire reduction in operating losses for the second quarter of fiscal year 2007 can be attributed to its reduction in inventory reserves.

Surely, Patrick Byrne, who used conveniently used pro forma adjusted non-GAAP numbers to hype Overstock.com's purported turn around, could have explained how book keeping entries involving inventory reserves produced increased gross margins.

In addition, we cannot discount the possibility that inventory reserves booked by Overstock.com in previous quarters and in the current quarter is accurate.

Award winning forensic accounting expert, Tracy Coenen, examined the possibility of inventory reserve manipulation by Overstock.com. The company has on occasion made sporadic disclosures about the effects of taking excessive reserves or understating reserves:

If we underestimate our reserves or allowances our gross margins, and net income, if any, will be overstated (or our net loss, if any, will be understated). Contrarily, if we overstate our reserves or allowances, our gross margins and net income, if any, will be understated (or our net loss, if any, will be overstated). [Emphasis added.]

Therefore, if Overstock.com took excessive adjustments on inventory to reduce its value below market in prior periods, gross margins would be inflated in future periods. Likewise, if a company understates reserves, it inflates gross margins during the current period and reduces gross margins in future periods.

We do know that Overstock.com has made inconsistent and contradictory disclosures in the past about it inventory reserves and gross margins, which is the subject of part 2 of this blog post. In addition, we know that Patrick Byrne is the target of a Securities and Exchange Commission probe into financial disclosures and other issues at Overstock.com.

We don't know the extent to which the reduction of inventory reserves during the second quarter of fiscal year 2007 resulted from the reversal of previous adjustments to market value or the reduction of previous excessive reserves. However, we do know that the reduction of inventory reserves during Overstock.com's current quarter reflects the reversal of previously booked adjustments (whether or not excessive), which increased gross margins, and does not necessarily represent an underlying economic improvement.

The resulting increase in gross margins from any reversal of inventory reserves increases operating income and EBITDA. During the second quarter of fiscal year 2007, Overstock.com reduced its inventory reserves by $2.7 million which resulted in an increase in gross margins, reduction in operating losses, and improvement in EBITDA of the same amount.

Consider the effects of a reversal in structuring expenses from a prior period

According to Overstock.com's 10-Q for the second quarter of fiscal year 2007, released after the earnings conference call:

During the second quarter of 2007, the Company reached an agreement to terminate the Indiana warehouse facilities lease in its entirety effective August 15, 2007 for $1.9 million, resulting in a reversal of restructuring expense of approximately $1.0 million.

The "reversal of restructuring expense of approximately $1.0 million" resulted in increasing Overstock.com's pro forma aka "adjusted" EBITDA by $1 million.

Consider the effects of both the reduction of inventory reserves and reversal of restructuring expenses on Overstock.com reported turnaround

Examine the table below which includes the effects of both the reduction of inventory reserves and reversal of restructuring expenses (click on image to enlarge):

Taking into account the reduction of inventory reserves and reversal of restructuring costs during the second quarter of fiscal year 2007, Overstock.com's EBITDA improvement mostly disappears and its EBITDA and pro forma aka "adjusted" EBITDA becomes a negative amount. Overstock.com simply adds back allegedly "nonrecurring" expenses, but fails to deduct certain one time benefits.

As a minimum, Overstock.com should have disclosed the nature of the material contribution resulting from the reduction of its inventory reserves in reducing operating losses and improving EBITDA in the MD & A section of its 10-Q for the second quarter of fiscal year 2007. In addition, it should have prominently highlighted the material effect of its reversal of previous restructuring charges in its pro forma aka "adjusted" EBITDA.

Despite the use of pro forma aka "adjusted" EBITDA by Overstock.com during the current quarter, Patrick Byrne contradicts his earlier statements about EBITDA and pro forma accounting

On March 6, 2006, Patrick Byrne was interviewed by Greg Sandoval for an article entitled "Newsmaker: CEO in the Hot Seat" published by c/net news.com:

What are Overstock's problems right now, and when will the company be profitable?

Byrne:

I don't know. 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. [Emphasis added.]

I guess Patrick Byrne uses EBITDA when it is to his advantage to hype Overstock.com's financial performance. He uses a non-GAAP pro forma aka "adjusted" EBITDA to promote the company while ignoring the effects of reductions in inventory reserves and reversals of previously booked and so called "nonrecurring" expenses.

Overstock.com never came close to crossing the "billion-dollar mark" for fiscal year 2006. Its revenues ended up at about $796 million for the fiscal year. Despite Patrick Byrne being "comfortable" with "an EBITA-profitable" year for fiscal year 2006, Overstock.com EBITDA fell far off the mark. I guess Patrick Byrne needed more than a "little luck."

In addition, Overstock.com's use of EBITDA and pro forma aka "adjusted" EBITDA during the 2nd quarter of fiscal year 2007 ignores the underlying quality of current reported earnings. Patrick Byrne hypocritically uses "a phony accounting standard--pro forma" when it pleases him.

So, whose non-GAAP pro forma aka "adjusted" numbers are more meaningful, the delusional paranoid Patrick Byrne, who is a target of a federal investigation, or this convicted felon and former CPA? When a public company uses non-GAAP pro forma numbers to hype up its results, there is always a slippery slope as to what to include and not include in its calculations.

About two years earlier, in the second quarter fiscal year 2005 Form 8-K, Patrick Byrne chided other companies for their propensity to report one-time charges and their focus on EBITDA:

I worked at First Manhattan in the early 1990's. One of the first lessons I was taught was to watch out for companies with "one-time" charges, for rarely, if ever, did they turn out to be truly, "one-time." Subsequent experience confirmed this. Of course, the world had not really discovered "restructuring charges," let alone the mantra of "pro forma accounting" that the Internet would later spawn ("EBE: Earnings Before Expenses," as one wag put it). I was similarly discouraged from calculating EBITDA ("That cash either counts the day it went out the door when you bought that ice machine, or as it depreciated, and GAAP depreciation turns out to be a pretty good approximation of how equipment really depreciates," I was told).

The common failure of these variations is, it seems to me, this: they start by showing a way to look at a financial statement excluding certain events, but lead people to pretend that those events are not real. "EBITDA" might be a useful step in projecting the future cash needs of a business, but it misleads people into thinking that "depreciation" is not a real expense. Similarly, "restructuring" and "one-time" charges may in fact be only one-time charges, but that does not make them "not real" (and they usually turn out not to be "one-time" anyway). [Emphasis added.]

However, in Overstock.com's 8-K for the second quarter of fiscal year 2007, Patrick Byrne is now defending the company's use of EBITDA and pro forma aka "adjusted" EBITDA despite his previous statements deriding its usage by other companies. The 8-K went on to say:

During Q2 we generated $14.9 million positive operating cash flow and $2.0 million positive EBITDA, excluding restructuring costs ("EBITDA excluding restructuring costs" is a non-GAAP number....

EBITDA excluding restructuring costs (non-GAAP) - EBITDA excluding restructuring costs for the three months ended June 30, 2006 and 2007 was $(7.5) million and $2.0 million, respectively. For the six months ended June 30, 2006 and 2007, EBITDA excluding restructuring costs was $(14.0) million and $(146K), respectively. Restructuring costs primarily represent efforts to reduce our overall expense structure through the consolidation of our corporate office, data centers and warehouse facilities. Therefore, we believe that discussing EBITDA excluding restructuring costs provides useful information to investors because it is a representation of cash generated from the operations of the business if the company had not originally incurred these costs. [Emphasis added]

During the second quarter fiscal year 2007 conference call Jason C. Lindsey defended the Overstock.com's use of "adjusted" EBITDA and implied Overstock.com was profitable:

If you believe EBITDA is profitable and you believe that the restructuring charges really are one-time, or they are not recurring and that's your definition of pro forma then we were $2 million profitable this quarter.

During the second quarter fiscal year 2007 conference call, Patrick Byrne went on to hype the EBITDA metric that he previously derided and imply profitability, too:

We've recovered and we're actually EBITDA positive in the ... second quarter.

The problem is that Overstock.com has continuously reported ‘one-time’ items in the current fiscal year and previous two fiscal years leading any reasonable person to conclude that its costs relating to restructuring and discontinued operations has been anything but “nonrecurring.”

Worst yet, is that Overstock.com’s purportedly “nonrecurring” charges have been increasing at an increasing rate. For example for fiscal year 2005, so-called “nonrecurring” charges for discontinued operations totaled about $2.5 million. For fiscal year 2006, “nonrecurring charges” from discontinued operations totaled about $6.9 and restructuring charges totaled about $5.7 million. During the first six months of fiscal year 2007, Overstock.com’s “nonrecurring” charges for discontinued operations totaled about $3.9 million and restructuring charges totaled about $12.3 million.

The company has continuously engaged in highly speculative and money losing ventures that continue to this day. Overstock.com has gone through frequent and continuous changes in its operating structure which has led to consistent charges for restructuring and discontinued operations as cited above. Such speculative ventures have included OverstockB2B, collaborative filtering, m-commerce, Travel, Auctions, and Design Your Own Jewelry. All of these speculative ventures have produced losses and consumed significant amounts of shareholder capital. Newer speculative ventures such as Omuse have not produced any profits. Despite previous statements by Overstock.com, Omuse has yet to come out of beta.

It is highly misleading for Overstock.com management to make profitability assertions based on a non-GAAP measure such as EBITDA excluding restructuring charges. In addition, the reduction of inventory reserves and reversal of previous so called “nonrecurring” restructuring charges had a material impact on EBITDA and proforma aka “adjusted” EBITDA whose effect went undisclosed in Overstock.com’s calculations and disclosures.

Next in part 2:

I analyze certain disclosures by Overstock.com and statements by management about gross profits margins, inventories, and inventory reserves and raised the question as to whether the company is using inventory reserves to manage earnings.

Written by:

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