Online retail is widely regarded as the biggest threat to brick-and-mortar stores. What about the threat that online retail is to other online retail? Going up against the likes of Amazon, with its impressive scale and pricing power, has proven difficult for bricks-and-mortar as well as other online retail firms. With negative profitability, rising costs, and an overvalued stock price, Overstock.com, Inc. (NASDAQ:OSTK) ($15/share) is on October’s Most Dangerous Stocks list and is in the Danger Zone this week. Could OSTK be the next victim of the retail market?

Overstock’s Profits Are On the Decline

Overstock’s after-tax profit (NOPAT) has declined from $18 million in 2013 to $2 million in 2015, and even further, to -$6 million over the last twelve months (TTM). The company’s NOPAT margin has fallen from 1.4% in 2013 to -0.4% TTM, per Figure 1. The deterioration in Overstock’s profitability comes despite revenue growing 13% compounded annually from 2013-2015.

Figure 1: Overstock’s Growing Losses

Overstock.com NewConstructs_OSTK_DeterioratingMarginsandProfits_2016-10-31

[drizzle]Sources: New Constructs, LLC and company filings

Overstock’s return on invested capital (ROIC) has fallen from a once impressive 58% in 2013 to a bottom-quintile -4% TTM. It’s clear that Overstock’s business is showing significant signs of deterioration across multiple key metrics.

Overstock.com – Compensation Plan Misaligns Executive Interests

Overstock’s executive compensation plan is weighted heavily towards equity incentive awards with a smaller focus on annual cash bonuses. The criteria for earning equity awards appear largely subjective, as Overstock’s proxy statement states that “the number of awards are determined by the compensation committee on the basis of management’s recommendation and the comp committee’s subjective views of the relative ability of key employees to make positive contributions to the company.”

Annual cash bonuses are paid out through a company-wide bonus pool, of which the pool’s total value is determined as a percentage of a “measurement amount.” In 2015, this “measurement amount” was adjusted net income, which removed stock-based compensation, development project expenses, and general & administrative expenses, among others from net income. No bonuses are paid out unless the “measurement amount” exceeds a target level. With significant leeway in the calculation of this “measurement amount,” one must question whether executive interests are correctly aligned with that of shareholder interests.

In either case, executives are incentivized by metrics that do little to create shareholder value and investors should be wary of heavy use of stock price as an incentive. We would much rather see executive compensation tied to ROIC, as there is a clear correlation between ROIC and shareholder value. Currently, OSTK’s executive compensation plan has done little to create shareholder value, as its economic earnings, the true cash flows of the business, have declined from $16 million in 2013 to -$16 million TTM.

Non-GAAP Metric Ignores Economic Reality

Overstock doesn’t represent the most egregious abuse of non-GAAP metrics we’ve come across in our Danger Zone picks, but its use of “contribution” still distracts from the economic realities of the business. Overstock’s “contribution” is calculated from gross profit and removes the effect of sales and marketing expense and Club O Rewards & gift card breakage. The issue with “contribution” is management claims it provides additional insight into the firm’s operations while it actually diverges significantly from economic earnings. See the dangers of non-GAAP metrics for more details on how companies can abuse non-GAAP.

Per Figure 2, Overstock’s “contribution” has increased from $172 million in 2014 to $187 million over the last twelve months. Meanwhile, economic earnings have declined from $7 million to -$17 million over the same time. Investors following “contribution” would believe Overstock’s business to be in much better condition than those calculating the true cash flows of the business.

Figure 2: Discrepancy Between Non-GAAP & Economic Earnings

NewConstructs_EconEarningsVsContribution_2016-10-31

Sources: New Constructs, LLC and company filings

Negative Profitability In The Cutthroat Retail Industry

Overstock’s business, an online retailer of home goods, jewelry, apparel, electronics, and more, places it in one of the most competitive industries in the world. Retailers across the globe compete with one another in terms of product offering, pricing, availability, delivery time, and even ease of use. At the same time, Overstock.com is not only competing against Internet retailers such as Amazon (AMZN), Etsy (ETSY), Wayfair (W), eBay (EBAY), or Alibaba (BABA), but also thousands of brick-and-mortar stores operating across the country such as Bed Bath & Beyond (BBBY), Wal-Mart (WMT), and Williams-Sonoma (WSM).

Originally, Amazon’s practice of cutting prices to grow market share was believed to be one of the most significant threats to traditional retailers. However, online retailers are just as susceptible to this competition, Overstock included. Per Figure 3, Overstock earns an ROIC and NOPAT margin well below its main Internet and traditional retail competition. In fact, the only company with lower profitability is Wayfair, a previous Danger Zone pick. With negative profitability, Overstock’s ability to compete on price is diminished, and with increased discounting across the sector, the costs to acquire customers are increased, an issue we’ll touch on later.

Figure 3: Overstock’s Profitability Lags Nearly All Competition

NewConstructs_OSTK_PeerProfitabilityComparison_2016-10-31

Sources: New Constructs, LLC and company filings 

Bull Hopes Ignore Deteriorating Economics

In online retail, the bull case generally centers on a firm’s ability to attract traditionally brick-and-mortar shoppers to its online offering. Retailers can take many approaches to reach this goal, including under pricing the competition, providing a niche offering unavailable elsewhere, or even customer loyalty programs. The problem with many of these approaches is that they can be costly to a retailer’s margins, as noted above, and greatly undermine the firm’s ability to market to new customers while maintaining profitability.

We see this scenario playing out at Overstock.com, as the firm has increased coupons, sales, and customer rewards programs in an attempt to grow the business. However, the cost per unique customer is continually rising, making each customer worth less to the firm. Per Figure 4, Overstock’s cost per customer has grown from $12.52 in 2Q13 to $18.36 in 2Q16.

Figure 4: Cost Per Customer Threatens Future Profitability

NewConstructs_OSTK_RisingCostPerCustomer_2016-10-31

Sources: New Constructs, LLC and company filings

At the same time, the company’s cost of good sold and sales & marketing expenses are growing equal to or faster than the revenue generated by new and existing customers. Since 2011, revenue has grown 9% compounded annually, the same as cost of goods sold. Sales & marketing expenses have grown 15% compounded annually over the same time frame.

Meanwhile, the executive team at Overstock.com is expanding its interest in side businesses such as blockchain software and bitcoin currency, with claims that it can revolutionize the market and business as a whole. We feel these non-core operations are more of a smokescreen to distract from the growing issues at the business, namely the consistently growing cost to acquire a new customer. Without significant cost controls, the business will be unable to meet the expectations embedded in its stock price.

The largest risk to the bear case is what we call “stupid money risk”, which is higher in today’s low (organic) growth environment. Another firm could step in and acquire

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