Monday, May 09, 2005

Patrick and the Amazing Technicolor Dreamcoat, Part I


Burger King, the long-struggling fast-food chain, is struggling no longer. Under smart new ownership and a smart new CEO, the chain has stopped chasing trends and gone back to its core customer—young, male and hungry—with big burgers and fast service. It even brought back the old, famous ad slogan, “Home of the Whopper.”

And the strategy is working: sales are up for the first time in years; franchisees are happy; and an IPO may be in the cards.

Now, speaking of whoppers, here’s a trivia question for those of you who think you know your business facts: “Earth’s Biggest Discounter™” is the trademarked slogan for what discount chain?

No, it’s not Wal-Mart’s—that would be, “Always Low Prices. Always.” Nor is it not Costco’s—Costco has none. (The customer knows what Costco stands for, and Costco wouldn’t waste the money registering something anyway.)

If you guessed eBay, you were close (eBay calls itself “The World’s Online Marketplace®”)…but wrong.

In fact, it is Overstock.com that has trademarked “Earth’s Biggest Discounter™”. As Overstock CEO Patrick Byrne gloated to shareholders, “Now that we have occupied the ground of Earth's Biggest Discounter, we are making it prohibitively expensive for any of our would-be competitors to aim for the same space.”

In case you never heard of it, Overstock.com is an Internet seller of closeout and other merchandise that generated just under a half-billion in sales last year— at a negative operating margin. Half of those sales don’t even “belong” to Overstock, being pass-through sales for merchants who list their wares on Overstock’s site and deliver the goods themselves.

To put in perspective those $250 million of annual sales Overstock makes directly to its customers, Wal-Mart generates three-times that amount each day. Costco generates that amount every two days. Even Big Lots, a publicly traded closeout retailer ranking low on the list of Earth’s Biggest Anythings, generates $250 million roughly every 20 days.

So how, you might ask, does Overstock.com get away with calling itself “Earth’s Biggest Discounter™”?

Well, for one thing, as we have already seen, “Home of the Whopper” was taken.

For another, and based on an extensive review of the company’s conference calls, shareholder letters, interviews and earnings reports, it would appear that CEO Patrick Byrne has at times demonstrated a fairly elastic notion of the bounds of plausibility, going back even before Overstock came public in 2002.

Asked in June 2001 by the Wall Street Transcript, “Where would you like to see the company in the year 2004?” Byrne said: “I would want to see us well over $400 million and as profitable as hell. Making a ton of money. I want to see that next year.”

When the books actually closed on 2004, Overstock had seen only two profitable quarters in the intervening three years, neither of them “profitable as hell,” and both of them followed by a return to red ink.

That a CEO who misses such a big target by such a wide mark, and then has the notion to brand a relatively insignficant web site “Earth’s Biggest Discounter™”—and receives little apparent scrutiny from Wall Street’s Finest or even his own Board of Directors, owes itself to several factors, in my view.

First, even the most skeptical observer would acknowledge that circumstances change in this world, and goals which looked both worthwhile and obtainable in 2001 might no longer be obtainable or worthwhile in 2004. As emphatically as he declared his desire to be “profitable as hell” back in 2001, Byrne now emphatically declares his desire to grow as fast as possible while leaving profits to come later. This change may be either appropriately flexible business management, or good spin, depending on your point of view.

If it's good management, Byrne has an indefinite length of time to make good on becoming “profitable as hell.” If it's merely good spin, however, Byrne's growth-over-profits mantra may be masking underlying issues at Overstock.com, as we shall explore later.

Second, there is Patrick Byrne’s pedigree. Not only is he the son of Jack Byrne, a legend in the insurance business and longtime favorite of Warren Buffett, but he once worked for Buffett, running one of the smaller Berkshire companies.

Byrne wears his association with the Oracle of Omaha like Joseph’s Amazing Technicolor Dreamcoat, frequently quoting not only Buffett, but also Charlie Munger, the less-heralded of the Berkshire duo, and mimicking the Berkshire “Owner’s Manual” as well as Buffett’s folksy, direct letters to investors.

Since Buffett is a famously decent, honest and brilliant investor, it may stand to reason that any ex-employee/son-of-a-friend-of-Buffett may be decent, honest, and brilliant.

Third, of Overstock’s five-person Board of Directors, three have strong connections to Patrick Byrne. One being the Chairman of the Board (Patrick Byrne); the second being the Vice-Chairman of the Board (Patrick’s dad, Jack Byrne); the third being Gordon Macklin.

Who is Gordon Macklin? Macklin, who served from 1998 to 2002 on the Board of Worldcom (yes, that Worldcom), also served on the board of Jack Byrne’s insurance company, White Mountains Insurance Group. At the same time as Patrick Byrne.

That a majority of the Overstock Board is related either by blood or by company affiliations goes a long way to explaining why the Board has apparently never seriously asked itself why a company generating one one-thousandth the sales of Wal-Mart is going around calling itself “Earth’s Biggest Discounter™”.

Wall Street, however, has no such excuse—and yet that very basic question appears not to have occurred to the half-dozen analysts who participated in its recent conference call.

To give Patrick Byrne credit where it is due, this gullibility among Wall Street’s Finest may owe itself to the fact that Overstock did hit one of Byrne’s long-stated goals over the course of 2004—to raise gross margins from the 10% range to the 15% range.

Skeptics would point out that the company managed to lose money when those margins were 15% just as easily as when they were 10%, but I am trying to explain Byrne’s credibility with Wall Street analysts—and hitting one target goes a long way towards doing so.

Yet even upon reaching the margin milestone, Byrne dug his own credibility gap to careful readers of his shareholder letters. For in the final quarter of 2004, he told his shareholders emphatically that “15% is the right level” for margins; and shareholders “are not going to see” further margin improvement:


Q4 2004 Letter:
Here is the punch-line: I now see another 250 basis points we can squeeze out of logistics, but these are, I fear, the last. Furthermore, shareholders are not going to see them: as in the coming quarters we scrape these savings out of the system, we will in one way or another pass them on to the consumer. …. I think 15% is the right level for our margins as it will provide great prices for our customers and a strong return to you, Overstock's owners...

Yet just three months later, following a surprisingly large first quarter loss, Byrne retracted the 15% “right level” of gross margin and claimed it was “a misinterpretation”:


Q1 2005 Letter:
We think there are still basis points to be added in shopping margins [above 15%]…. To correct a misinterpretation from three months ago: I said we might pass some of these dollars to consumers in the form of lower prices if it saves us more dollars in marketing than we pass on…


Readers will see that Patrick Byrne in fact did not write “we might pass on some of these dollars to consumers.” He wrote “we will.” And not a soul on Wall Street called him on either the flip-flop itself or his attempt to blame it on “a misinterpretation.”

But does it matter?

Does a CEO looking for good news somewhere in a press release of negative surprises—an electronics deal “I blew” that cost $600,000; a $2.6 million “binomial [sic] marketing experiment that failed”; a highly touted yet unsuccessful $1 shipping promotion—deserve scrutiny for trying to spin something his way?

As somebody who’s watched executives spin their companies into the wall over the last 25 years, I think so.

I have noted in past postings that Byrne is one of the more aggressive CEOs when it comes to attacking short-sellers—and in my experience, CEOs who obsess about short-sellers tend to be the ones who have something worry about.

What is interesting is that Byrne himself pretends not to obsess. He tells his shareholders thusly in one letter:


The elephant in the room during our conference calls and other meetings is the fact that out there there are a bunch of short-sellers and their sycophants who bad-mouth every thing I do or say. Eventually the nasty things they write make their way to my desk. It is OK with me. I practice Buddhist non-attachment on such matters. I "walk past the barking dog."


And yet, on conference calls, Byrne not only does not walk past the barking dog, he engages the dog in a debate:

To David Rocker:
“Well my research says…you're short us and he [reporter Herb Greenberg] is out there writing articles like that. …I think it's clearly very incestuous and it's a little disingenuous of him to be saying he doesn't have a position while he's writing an article like that. It sounds to me that you ought to be -- ought to be more careful about what you post publicly, Mr. Rocker.”


And for good measure, Byrne even comes up with a name for the one of the barkers:


“Greenberg of course, Lapdog Herb we call him...”

Indeed, for a guy who practices “Buddhist non-attachment,” Patrick Byrne can curse with the best of them:


“Out there are three investment banks that are the back offices of the real short selling… Last night someone called me and told in particular , there’s a guy out there…who is spreading this rumor from one of these banks…. You know, A) it is total bullshit; B) anybody who even wouldn’t know that is bullshit on the face of it should sell this stock….”

In sum, while Patrick Byrne quotes Chinese proverbs and Buddhist philosophy to Overstock shareholders, he spends a portion of each conference attacking the barking dogs:

“The tools of Satan are among us. They are trying to ruin things….”


So, under the old Shakespearan rule of thumb that the lady who doth protest too much might be worth keeping an eye on, let's look more closely into this question of growth versus profits, and see if the facts mesh with the spin. It is not so hard to do, given the extensive record of conference calls and shareholder letters.

For example, on the January 2004 earnings call, Byrne rapturously described his ability to analyze so-called “repeat” customers—those customers that buy more than once. He said:


We are getting a lot better at the analysis of repeat [customers]…. There were wonderful monotonic relationships we are discovering between frequency of buying, length of time between buying, categories that people are buying…. I am not sure we will release that [information] because that is the colonel’s secret recipe.

Despite his caution at revealing the “colonel’s secret recipe,” only six months later Byrne volunteered precise data about Overstock’s repeat customers on the July 2004 call:


One metric we look at is if somebody spends a dollar in month X what do they spend in the remainder of month X and month X plus one. That number has over 3 or 4 years trended from 19 to 31 cents.

Oddly enough, in April 2005—nine months after this to-the-penny analysis of repeat customer purchasing—Byrne declined to provide that type of analysis on the grounds that he couldn’t do it. Indeed, he makes it sound as though Overstock never could do it:


Analyst:
I’m wondering if you can provide a little color on what you’ve seen with order frequency for a customer—is it 1.2, 1.5 times a year?

Byrne:
I’m not going to give you that number, but I will give it to you next quarter. I hate to say it, but these are the kind of numbers that we’re just getting around to looking at, which some people are going to find laughable, because it’s like step one in the catalogue company to know these things. But three months from now, I should be able to give you that number. Is that cool?

With a brazen “Is that cool?” Patrick Byrne prevented an embarrassing flare up from an analyst who probably knew Byrne had tossed around such numbers in the past, but perhaps did not want to get in Byrne’s bad graces, alongside the shorts, by pressing for answers.

Since the analyst did not press, we will, for there are other instances in which Patrick Byrne’s enthusiasms and explanations appear to change, sometimes from the shareholder letter to the conference calls; sometimes from one call to the next; most usually from one letter or call to another down the road.

Tomorrow we will, figuratively speaking, roll the tape, to see if we can identify such inconsistencies and determine whether they are merely the by-product of spin-control or indicate flaws in the Overstock's growth now, profits later playbook.


Jeff Matthews
I Am Not Making This Up


The content contained in this blog represents the opinions of Mr. Matthews. Mr. Matthews also acts as an advisor and clients advised by Mr. Matthews may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Matthews' recommendations.





8 comments:

The Unknown Broker said...

With all due respect to the Burger King folks -- and I think they make a dandy sandwich -- I am beginning to think that Dr. Byrne, by virtue of his relentless reinvention of facts should be the rightful owner of the "Whopper" name and slogan.

Burger King may be "The Home of the Whopper" but Dr. B and Overstock should at least be able to use their version of the slogan.
Perhaps, "We Told A Whopper"?

And while Jeff's analogy of the "Amazing Technicolor Dreamcoat" is an apt one, might I suggest that there is another kind of garment involved here?

Something about "the emperor's new clothes" rings a bell.

Good work as usual Mr. Matthews.

mfairview said...

A few things from your article.

1) "In case you never heard of it, Overstock.com ..."

How could your readers never hear of OSTK, you bash it every 3 days.

2) "To put in perspective those $250 million of annual sales Overstock makes directly to its customers, Wal-Mart generates three-times that amount each day..."

Funny comparison.. How do they fare against Big Oil? Oh and how long does it take for RAM Partners to achieve 250M?

3)"Who is Gordon Macklin? Macklin, who served from 1998 to 2002 on the Board of Worldcom (yes, that Worldcom..."

You intentionally forgot he also was the president of NASDAQ (your bread and butter for 17 years).

4) "Readers will see that Patrick Byrne in fact did not write “we might pass on some of these dollars to consumers.” He wrote “we will.” And not a soul on Wall Street called him on either the flip-flop itself or his attempt to blame it on “a misinterpretation."

You are an absolute hawk Jeff. Nice dig! Why, pray tell, don't you call into the CC and grill Patrick but instead use your blog to Arm chair QuarterBack?

mfairview said...

btw- Did I get everything right below?

--------

"Street.com, for better or worse, is irrelevant to me, which is why I do not write about it."

Hm.. Interesting.. Sure I'll bite.. Try these facts.

David Rocker is head of Rocker Partners, a large hedgefund known for shorting stocks (they've also manage to short several stocks that coincidentally (or is it conveniently) appears on the Reg SHO)

You worked for Rocker Partners for several years.

You write for Street.Com (btw- your article on shorting OSTK was printed 2/05 which means you were still writing articles for Street.Com while your blog was active which is contrary to your claims)

David Rocker is a known big short on OSTK (as are you)

David Rocker is also friends with Jim Cramer (the one that started street.com)

"Ace Reporter" (your words) Herb Greenberg writes for street.com.

David Rocker holds MILLIONS of shares of Street.Com (a ridiculous company to invest in purely on financials-- I wonder what else is going on there?). In fact, aside from Jim Cramer, David is the second largest shareholder of Street.com

David Rocker called into an OSTK cc and publicly argued with Patrick Byrne (Why no rant from you about this blatant public act I wonder?)

Patrick Byrne has also met David Rocker elsewhere where he claimed DR incites arguments.

Sufficit to say David Rocker and Patrick Byrne are not friendly with one another.

You, "Ace" and Cramer all bash OSTK regularly (You really are the worse of the bunch with about 1 slam every few days).

Also, since you enjoy pointing out Byrne's misstatements, how about Jim Cramer claiming to have ONLY met David Rocker once at the local grocery store. I suppose he forgot about the time David was on his show and the fact that David owns 2M+ shares of his company's stock.

Did I cover everything and do you see why your connection with street.com is material to the OSTK conversation? Focused enough for you?

As I previously mentioned, you guys are so incestuous, it makes Deliverance look like a Disney film.

k9thunder said...

Well TRUTH hurts... Especially to mfairview.

Selective at best yet he cannot seem to substantiate his "allegations". Got to be Bobo in disguise. ;)

I did see Cramer and Kudlow in early Jan interviewing Byrne. What a joke he was with his big smile in red sweater... Actually both Cramer and especially Kudlow were too kind to this immature jerk Byrne.

Uh, some historical lesson for mfairview. Numerous academic studies have shown that heavily shorted stock do come down, quite a bit. Just look at other favorite shorts like Krispy Kreme and Taser to name a few with hoaky fundamentals and lots os HYPE.

Hey wait a minute, at least these shares don't have a dumb ass con man acting as a front man!

mfairview said...

Uhm.. What are you talking about thunder? If "allegations" are in reference to my Rocker-Matthews-Greenberg-Cramer connection, please point out which part of it is false? Jeff knows it to be true which is why he hasn't responded.

Speaking of allegations, how about a link to your "Numerous academic studies".. I'd love to be rich and retire on that advice!

smr said...

mfairview:

Well, one thing you've said that's false is that Herb Greenberg works for TheStreet.com, which he doesn't. He's at Marketwatch now.

mfairview said...

I stand corrected. However, "Ace" did work for TSCM for many years!

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