Summary
Bullish investors hoped cash flow from retail business could fund promising cryptocurrency and blockchain bets.
Company now plans to boost marketing to try and match growth rates of Amazon and Wayfair in e-commerce business.
Both businesses running losses will prompt massive financing needs, which will likely squeeze equity investors immensely.
Shares of discount home goods retailer Overstock.com (OSTK) surged more than 400% between August 2017 and January 2018, reaching nearly $90 per share, on hopes that the company would become a pure-play cryptocurrency/blockchain infrastructure business that would eventually far exceed the size of its legacy e-commerce retail business. The company's equity market value hit $2.25 billion, up from $450 million before the Bitcoin-related bubble reached its peak. Overstock even went as far as to announce that they may sell the retail business outright to fund these other bets.
As with any bubble, there was little reason to believe that their side business, which has yet to produce any revenue, was worth anywhere near the $1.8 billion of incremental value investors gave it at the peak. As a result, OSTK shares began retracing the gains, falling into the high 40s by the time the company reported its fourth quarter 2017 financial results on March 15th:
At this point, OSTK shares still had a baked-in premium for their non-retail business, but at least it was much smaller. After getting a $100 million investment from a George Soros backed hedge fund (a warrant priced just above $40 per share, which has since been exercised), it looked like funding would not be an issue for whatever blockchain related ventures they would pursue.
However, Overstock has now shifted strategies completely and decided not only that they will not sell their e-commerce business, but they will now ramp up marketing spending to compete with the likes of Amazon (AMZN) and Wayfair (W), which are growing much faster than Overstock.com. This move is likely to dramatically reduce the upside for equity investors.
First, the e-commerce business was not exactly throwing off tons of cash flow to begin with. In fact, since 2011 the company never earned more than a 5% free cash flow margin, and has actually had negative free cash flow during each of the last three years:
As you can see, OSTK has cumulative free cash flow over the past seven years of just $41 million. That is why the retail business was only valued by Wall Street at $450 million before the blockchain story began to take over, despite the company having more than $1.7 billion of annual revenue. Simply put, Amazon and Wayfair were already beating Overstock badly, and that is unlikely to change.
The company disagrees, and plans to lose money in order to boost revenue growth since that strategy has worked so well for the stock prices of Amazon and Wayfair. What they don't seem to realize is that customers like Amazon and Wayfair better due to super-fast shipping, great prices, and enormous selection. Amazon can offer this because they have a two-decade head start. Wayfair does it by letting their suppliers hold the inventory and direct ship to customers. Overstock, on the other hand, has no competitive advantage. Why else would Wayfair be able to grow revenue from $600 million in 2012 to $4.7 billion in 2017, while Overstock's revenue during that same time only increased from $1.1 billion to $1.74 billion?
To fund this marketing spend, Overstock just issued 4.6 million new shares, bringing total dilution to equity holders to more than 7 million shares (28% of the company), including the aforementioned Soros investment. If this same corporate strategy continues (spend money to increase unprofitable sales at the retail business, while funding losses within various blockchain divisions that don't even generate revenue, let alone cash flow), equity investors are going to be left holding the bag. And yet, the stock still trades at $37 right now, more than double the level of late last year.
Just how overpriced are the shares still? Well, the new share count is 32 million, giving the company an equity value of roughly $1.2 billion. If $450 million (the market's view in 2017) is the right price for the retail business, then the blockchain divisions are now valued at $750 million. However, given that the company will now be burning even more cash (cash burn was $59 million last year!), you should expect more future dilution.
Unless you believe that a subpar e-commerce player will ultimately become a leader in blockchain technology, there is little reason to think that Overstock today should be valued at three times the amount it was eight months ago. With two money-losing divisions under its roof, equity investors should tread very carefully unless OSTK can prove at least one of two things: they can make money on blockchain technology, or they can take market share (profitably) from Amazon and Wayfair in retail. From my perch, neither seems overly likely.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Bullish investors hoped cash flow from retail business could fund promising cryptocurrency and blockchain bets.
Company now plans to boost marketing to try and match growth rates of Amazon […]