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Overstock.com -- Is Fulfillment Partner Business Defensible?


PaulD
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I've followed the board discussions on OSTK for a few weeks and just finished diving into the business myself. What I'm finding intrigues me, and I'm eager to get the forum's input. Please humor me this mini-analysis and let me know if you have any insights into the questions of Overstock's competitive advantage (or lack thereof) at the end.

 

I'll confess I'm pretty much in love with the economics of its fulfillment partner business.  Nearly 80% of revenues come at no cost to the company. Fulfillment partners own and manage the inventory and ship orders in the company's nice "O.co" boxes. Overstock keeps up the website, pays $60M/year for marketing, collects the cash, and takes their roughly 20-25% piece of the action before reimbursing the suppliers. It's almost entirely frictionless, and the pre-tax ROIC is 48% on what should be deflated earnings numbers.

 

In 2010 OSTK did $880M revenue this way, producing $167M in gross margin dollars. That covered all but about $8M of its operational expenses. (Its much smaller and less profitable "direct" business brought in another $23M in gross profit and pushed the company over the line for about $14M net earnings.)  The fulfillment business has grown from $660M to $880M in two years while remaining steady at about 19% gross margins.

 

If this sort of growth can continue, it's no stretch to see Overstock post some impressive earnings numbers in the next 1-2 years. Conservatively, I see them passing $40M net earnings, and it's not hard to imagine that number being closer to $80M. At a 24M share count, they don't need a crazy EPS multiple to see the price take off. If...

 

If this happens, I think it's is all done on the back of the fulfillment business. Ignore the lawsuits, the auction business, the cars, real estate, vacations, etc. At best, they're free options if the fulfillment business succeeds. If...

 

My "if" is ...if the fulfillment partner business is sustainable. The big boys of internet retailing also like the idea of hanging onto their capital and letting partners pony up for inventory costs. (See this article if you're interested: http://ak.buy.com/buy_assets/marketplace/IR_Mag_Sep_2010.pdf.) So, if they start gunning for the opportunity, does Overstock have any moat to offer protection over the next few years?

 

First, it would seem that Overstock's relationship with the fulfillment suppliers is absolutely key. Why do they stay loyal to Overstock? It seems as if it would be very easy to bolt to, say, Amazon and sell on its outlet site. The fact that they don't could be critical. I estimate that Overstock charges its suppliers 20-25% commissions. Amazon claims to charge only 12-15% for most merchandise categories. To Overstock's credit, that mark-up is akin to holding pricing power. Any insights into why this might exist?

 

Second, are there dynamics unique to the surplus/overstock business that would prevent suppliers from selling through Amazon, Buy.com, etc.? At the very least, would they not want to hedge bets by selling on multiple sites? I confess I know very little about those industry dynamics.

 

Finally (and related to the second question), if Amazon really decided to chase down Overstock, why couldn't it just offer the same merchandise selection, promote it more heavily, and price it to match or barely beat Overstock? There seems to be an element of the sleeping giant at play here. If Overstock's growing success wakens Amazon, can the giant dig into its $26B chest of cash and obliterate Overstock at will?

 

There are reasons Fairfax is in this. There are reasons Sanjeev likes this business. The upside is obviously exciting, but I have a hard time seeing either of them buy into an exciting story without having a strong sense of protection from the downside. Any insights into what that downside protection might be?

 

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First, it would seem that Overstock's relationship with the fulfillment suppliers is absolutely key. Why do they stay loyal to Overstock? It seems as if it would be very easy to bolt to, say, Amazon and sell on its outlet site. The fact that they don't could be critical. I estimate that Overstock charges its suppliers 20-25% commissions. Amazon claims to charge only 12-15% for most merchandise categories. To Overstock's credit, that mark-up is akin to holding pricing power. Any insights into why this might exist?

 

The product mix is different.  Thus the 20-25% estimate you get is actually not correct.  On the same merchandise, their commissions are similiar to Amazon's.  You also have to factor in Overstock's customer service, and there may be undisclosed back-end deals with suppliers for loyalty, etc.  This would be a very good question to ask on the Overstock webcasts.

 

Second, are there dynamics unique to the surplus/overstock business that would prevent suppliers from selling through Amazon, Buy.com, etc.? At the very least, would they not want to hedge bets by selling on multiple sites? I confess I know very little about those industry dynamics.

 

While Amazon provides a larger audience to market to, because there is so much product competition on there, suppliers may feel compelled to dispose of inventory through a smaller player where there is less similiar merchandise.  Overstock's actual mark-ups are on par or less than their competitors, thus they run through inventory cycles a hell of a lot faster than their competitors.  On affiliate merchandise, inventory turnover runs close to 40 times a year!  That's insane!  Amazon cannot touch that.  I believe Amazon's turnover on affiliate merchandise is somewhere in the high 20's.

 

Finally (and related to the second question), if Amazon really decided to chase down Overstock, why couldn't it just offer the same merchandise selection, promote it more heavily, and price it to match or barely beat Overstock? There seems to be an element of the sleeping giant at play here. If Overstock's growing success wakens Amazon, can the giant dig into its $26B chest of cash and obliterate Overstock at will?

 

Overstock is undercutting Amazon, especially if you include the loyalty programs to repeat customers.  Amazon cannot obliterate Overstock, without hurting it's own profitability.  Think Sam's Club to Costco.  Walmart could not kill Costco with their Sam's Club, because Costco's operations were just more efficient.  Overstock will make more money on less revenue than Amazon did, as they are just run much leaner and have higher inventory turnover.  Another example would be McLane's...running on such thin margins with high turnover.  Amazon's best strategy is to just buy Overstock if they ever threaten the moat - just like Walmart should have done with Costco!  Cheers!

 

 

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PaulD.  This is a great question and one I have been trying to figure out myself. 

 

In terms of the sustainability of Overstock’s partnership business I’m not sure I’m smart enough to figure out the sustainability of any tech company business over the long term.  I do find it reassuring that Amazon’s partnership business has been around for a while and Overstock seems to be doing alright. 

 

Patrick talks about online retailing being like Lake Michigan with enough business to go around for everyone.  I think as long Overstock can execute it will be difficult for them not to grow top line by 10%-20%.  My biggest concern is expense control, which in a low margin business is the difference between making $10m and losing $10m.  If they can grow 10%-20% and control costs they will do very well.

 

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