Excess inventory: value trap or hidden gem? (NASDAQ: OSTK)

    Happy couple tidying up their new living room

    RgStudio/E+ via Getty Images

    Company Description:

    stack (Nasdaq: OSTK) is an online furniture retailer in the United States. The company offers furniture and home d├ęcor such as beds, sofas and rugs.

    Controversial Ex-CEO of Overstock has acquired a blockchain-focused company called Medici Ventures in 2014, which contains several small businesses. This was turned into a fund in 2021, with Billion Ventures as the GP and overseeing investments in Medici Ventures. Therefore, Overstock is a company in the furniture and furniture industry.

    Markets seemed to like this combination as from Q1 2020 to Q3 2020, the stock price went from $2.5 to $120.

    Overstock.com price
    Data by YCharts

    Since then, the stock price has been extremely volatile, eventually dropping to a nearly two-year low of $32. The stock is still 9x up since 2020, but Overstock is clearly not a favourite.

    Investment thesis:

    Many investors consider a business with a tunnel vision, ignoring factors outside the company’s fundamentals, such as macro conditions. We love Overstock as a business, and we think Medici Ventures has potential. However, bad times await retail, especially retail that is not essential to consumers and has already generated significant revenue growth. Excessive stock may be undervalued, but if events do not cause a price movement, we may see stocks trade sideways. Given the risks we have identified, Overstock looks more like a value catch than a near-term bullish one. So we rate Overstock a Hold, until said market conditions improve.

    Marco terms:

    Global economic growth has been reduced as inflation continues to rise. Governments will have to raise interest rates further in order to control inflation, and it will likely reduce demand enough to cause a recession. Fannie Mae recently announced that a recession will occur in 2023, with Goldman Sachs stating that the probability was 35%.

    This presents a problem for overstocking because the demand for their products is driven by strong economic conditions and low interest rates. Consumers who lose their jobs or struggle to pay their bills won’t move out of their home, and they certainly won’t buy furniture. This will likely lead to lower sales in the short term.

    E-commerce retail sales seem to support this, as we see a steady slowdown after the third quarter.

    E-commerce retail sales

    Retail Sales for E-Commerce (FRED)

    More generally, we’ve seen a move away from growth stocks toward value play. Naturally, investors look for a safe haven for their money and invest in profitable businesses with good cash flows. Although excess cash flow is positive for cash flow, it only made $67 million in 2021.

    Finally, we observe a short yield curve reversal in April 2022. Recession has followed every reversal in the past few decades and is generally considered a leading indicator of recession.

    10 year treasury fixed maturity minus 2 year treasury fixed maturity

    10-year Treasury minus 2Y, otherwise known as the yield curve (FRED)

    We analyzed Overstock’s sensitivity to lower GDP growth and noted that in 5 of the past 7 years where year-over-year GDP growth has declined, Overstock revenue growth has declined more. The average stock price decline in the mentioned years was 10%.

    Therefore, it is very likely that economic conditions will deteriorate in the coming period. This will negatively affect the growth of Overstock, which will translate into a decrease in the share price.

    Sector Analysis:

    Growth in the furniture industry in the region is expected to be 4.79% (CAGR 2022-2026), with the largest portion being living room furniture, which currently constitutes 35% of total revenue.

    Overstock.com revenue

    Revenue growth by sector (Statista)

    Overstock has topped that amount in the subsequent five years, with a solid online penetration. They’ve improved their app and website, focusing on search optimization and a high-quality digital experience. This has renewed Overstock’s competitiveness, as they align their offerings with the needs of their target demographic.

    What’s slightly concerning is that Overstock’s main competition is much larger companies. Ikea, Amazon, and Walmart offer affordable furniture, while having a significantly larger range and resources. This will put Overstock at a disadvantage when trying to gain market share.

    Overstock.com Home Goods Experience

    Excessive Market Segment In Stock (Q1 2022 Investors Platform)

    Overstock’s main advantage stems from being lightweight, and working online only, similar to how shipping companies work. This allows for a degree of focus that their competitors lack. The following illustrates this, as Overstock is arguably punching above its weight.

    Overstock.com - Online American Home Furniture Brands

    US Furniture Brands by Revenue (Q1 2022)

    Overall, the industry has done, and is expected to grow, well over the long term. So far, Overstock has managed to absorb a lot of this. However, one must consider whether Overstock can continue to outpace major brands such as Target and Ikea, which have greater resources to drive growth.

    financial analysis:

    Overstock recently announced its results for the first quarter of 2022, and like many missed analyst estimates. The headline numbers are: EPS Non-GAAP $0.21 missed by $0.02 and revenue of $536 million missed by $37 million.

    Quarterly revenue decreased from 795 million in the second quarter of 21 to 536 million. In addition, Overstock’s active customers are down 26%, and orders delivered are down 33%. This reflects the effects of the over-buying of furniture we’ve seen during the pandemic, driven by rising property sales. Although this all sounds terrible, it may not be that bad.

    Existing home sales in the United States

    US Existing Home Sales (Trade Economics)

    The market must inevitably return to the mean as did all those who wanted to move on. We note that average revenue per customer has increased, which indicates that Overstock has been successful in encouraging increased spending by customers, through both marketing and more relevant offerings.

    Overall, we note that gross margins have improved over the past 10 years, indicating gains from economies of scale as business grows. This has allowed for a steady move towards free cash flow positivity, although this is still volatile and small. Given the nature of retail, this is not unexpected.

    Moreover, the liquidity of the business remains very strong. Cash is $493 million, compared to long-term debt of just $37 million.

    tZERO and Medici Ventures:

    Many are now aware that Overstock owns Medici Ventures, a fund that owns several small technology investments, including tZERO and Bitt. tZERO is the largest and a digital asset trading platform, with a focus on private companies looking to trade in a regulated market. Account holders can trade private tokens, NFTs, and regular cryptocurrencies. tZERO has received FINRA approval, being one of the first regulated cryptocurrency exchanges.

    According to BCC research, the blockchain market should reach 56 billion by 2026, representing a compound annual growth rate of 56.9%. This indicates that the growth of tZERO and others could be significant in the coming years, if they can capitalize on it. With the recent investment from ICE, and the emergence of David Goone as CEO, we can see tZERO really take off. The business has lacked real leadership and direction for many years, and ICE will bring some much-needed experience.

    What is worrying, however, is the lack of development so far. tZERO has been around for several years now and we haven’t seen anything to indicate that the company might be successful or reach the heights some have suggested. In the summer of 2021, tZERO was exploring sale options, which included a potential SPAC merger. This could mean that Overstock sought to get out of its position, rather than develop the company further.

    We haven’t said much about Medici Ventures except to inform the reader of the current situation. The reason for this is that there is not much to see. Much of the value attributed to Medici Ventures was when Overstock’s stock soared in 2021 due to the explicit belief that tZERO was bound to succeed. The truth is, we haven’t gotten there yet. Markets currently prefer value stocks that show profitability and free cash flow, and with Medici Ventures out there, we can’t help but agree with market sentiment that their value is nil.

    evaluation:

    The general market sentiment is bearish as investors prepare for the coming months, and this gives us a situation where most stocks are cheaper than they were several months ago. However, based on the following, Overstock is one of the cheapest.

    Overstock.com vs. Peer Price
    Data by YCharts

    “Cheap” stock does not necessarily represent good stock. When we put current ratings against key metrics, we find the following.

    Peer comparison stack

    Peer comparison surplus (Tikr Terminal)

    The furniture business varies greatly but Overstock performs very well. It outperforms on most measures while being cheaper.

    When we compare it to the broader online marketplaces, Overstock is less impressive. As we identified, cash flow is weak and is directly driven by weak margins. When we look at GPM and SG&A margins with overtime, we find that improvements have been slow. This makes it difficult to expect any significant improvement in the medium term.

    Overstock margins

    GPM / SG & A Margin – 2005-present (Tikr Terminal)

    Therefore, Overstock will likely remain in limbo, discount trading on best-in-class companies unless it can improve profit margins, while maintaining growth.

    We also considered the company’s cash flow potential.

    Discounted cash flow inventory valuation

    DCF Rating (Author’s own account)

    We used a 9.8% WACC, a very reasonable 10x exit multiplier and assumed a steady growth in cash flows over time. I should mention that my future assumptions are wiser than analyst consensus numbers.

    This gives us a rating in the range of 47.88-65.63. This indicates a significant rise in the value of the furniture business alone.

    Investment risk:

    The current beta of Overstock is at 3.87, which is a very high level. The stock has spent a lot of the past five years swinging from double-digit gains to losses. Potential investors should consider this as part of their portfolio composition.

    Final thoughts:

    Overstock may be the world’s most exciting furniture business with its investments in Crypto. These investments have great potential but unfortunately nothing to show for them. Currently, all we can judge is the furniture industry facing major headwinds. Consumer demand will begin to decline, as economic conditions deteriorate and inflation leads to a decline in discretionary income. Overstock’s competitive position is good, but we’re not sold long-term with that certainty, due to the amount of players they’re competing with. However, we believe that Overstock is undervalued, but for the above points, you do not believe that there will be a price movement required to return the stock price to fair value. Thus we classify Overstock a Hold.