Of Hunter S. Thompson, Giant Deformed Hedgehogs, and Doctor Patrick Michael Byrne

Overstock.com CEO and CBMG (Chief Binomial Marketing Guru), Patrick Byrne, was at the J.P. Morgan technology conference this week, answering questions about all things Overstock.

Actually, he only answered questions about a few things Overstock, because the questioners did not really get to all aspects of what Inspector Clouseau might have called “The rich tapestry of Overstock.com.”

Therefore, we will have to do it ourselves.

But before we get into the Top 10 List of Questions We Would Like Somebody To Ask Patrick Byrne, let me point out here that another mystery in the casebook of Overstock has been cleared up.

Specifically, the Case of the Reappearing Merchandise, in which we noted that furniture highlighted as “Almost Sold Out—Act Fast” in pop-up ads, mysteriously reappeared weeks after first being identified as “Almost Sold Out.”

This despite the fact that Overstock is supposedly a closeout buyer of overstocked merchandise—not a private label manufacturer.

Recall that we noted the product in question was sourced from Sitcom Furniture, a direct-import outfit offering product to U.S. retailers, and that the appearance of this kind of private label merchandise appeared to coincide with the dramatic rise in gross margins at Overstock, about which Patrick Byrne boasted on conference calls throughout 2004, crediting it almost entirely to better “logistics.”

Well, one of the questions Byrne got at the J.P. Morgan conference earlier this week concerned the $50 million Asian currency hedge Overstock put on the first quarter.

“Why hedge?” Byrne was asked.

“We do some buying in Asia,” he answered. “Not a tremendous amount, but we do…and we hedged what we felt was an adequate amount of currency.”

Since we have learned that it is better to watch what Patrick Byrne does rather than what he says, let’s ignore his protest that Overstock doesn’t buy “a tremendous amount,” and do the math ourselves:

Overstock did about $215 million of direct sales last year, with a $185 million cost of goods. Assume the cost of goods grows 50% in 2005, to roughly $270 million. By hedging $50 million worth of currency, Byrne is hedging almost a quarter of his company’s entire direct cost of goods.

Therefore, based on the math—not on Patrick Byrne’s spin—Overstock is in reality sourcing almost a quarter of its so-called over-stocked, closed-out merchandise from Asian manufacturers.

No wonder that stupid Newport Coffee Table, list price $434, “our price $179.99”—which began popping up back in March as “Almost Sold Out—Act Fast!” is still popping up on my Overstock.com web page.

Thus The Case of the Reappearing Merchandise and its sister mystery, The Wonder of the Rising Gross Margins, have been solved: Overstock.com sources product from Asia.

Moving on to the “Steal of a Lifetime” diamond purchase, not much new ground was broken at the J.P. Morgan conference.

Bizarrely enough—at least during the ten minutes or so of the question and answer session I listened to—Byrne never fully explained the profit-sharing scheme outlined in the Overstock.com 10Q, whereby the company splits profits on the diamonds with an unnamed special purpose entity (SPE).

Recall that according to the 10Q, the company cut a deal with an SPE for the purpose of buying diamonds in August, 2004—months before the sudden arrival on Byrne’s doorstep of two partners having a “nasty split” who, the way Byrne described it on April’s conference call, wanted to dump their diamonds at almost any price.

Those two fellows must be real players in the diamond business, don’t you think?

Instead of the logical, easy, and more profitable move, which is to simply get on a plane to either New York City or Tel Aviv and—as one of my diamond contacts who scoffed at Byrne’s story said—“just open up the briefcase and sell them,” this pair decided it would be better to give Overstock.com and its CEO, Patrick Byrne, the “Steal of a Lifetime.”

Can’t you just see these two guys, dirty and unshaven, driving across the Utah desert on Route 80 in a drug-addled, Hunter Thomspon-esque haze of Maui Wowie and 22 caliber gunsmoke, veering south on 215 to avoid the Giant Deformed Hedge Hog suddenly rising up before them blocking the entire mountain pass to the East and leading cops on a wrong-way chase down the entrance ramp at Route 190, bouncing off cars and fire hydrants before screeching to a halt in front of 6322 South 3000 and stumbling into the lobby of Overstock.com, banging the door shut behind them—loose diamonds and Peruvian flake spilling out of their pockets, pupils dilated and eyelids twitching, one firing at the blinking electric bats swooping down from the light fixtures while the other screams at the receptionist to “get Patrick out here right now!”… And suddenly Byrne appears, a vision to behold, serene in his Buddhist-like detachment, sizing up the situation in a second and offering the cowering dogs $7.2 million on the spot—just like that.

Deal done, he scornfully whips the pair with his belt and drives them from the lobby into the strong arms of the waiting, grateful Utah troopers—the “steal of a lifetime” safely done, the loot on its way to a vault on 47th Street in the heart of New York’s diamond district.

After all, who in their right minds would dump diamonds for $1.3 million less than their actual current value?

For that is what Byrne claimed on the conference call about the diamonds for which he paid $7.2 million, and he repeated that claim this week: “We…could turn around and flip them for $8.5 million and they probably have a good retail value of $10-$12 million.”

While not exactly the Hunter S. Thompsonish scenario envisioned above, Byrne also repeated his statement that it was a deal quickly done: “It was just an exceptional deal that happened sort of in an afternoon.” And so, with no further ado, the Top 10 List of Things We’d Like To Hear Somebody Ask Patrick Byrne (the presumption being, of course, we would get a straight answer):

1. Who bought the diamonds? You said “we did do a very large diamond buy” on your call, but the 10Q says it was a special purpose entity (SPE). Did you buy them, or did friends of yours buy them?

2. If you in fact bought the diamonds, and considering the fact that you yourself have admitted blowing substantial deals in the past (an electronics deal last quarter, the Franck Muller watches, FarenHYPE 9/11 etc.), why would the board let you buy $7.2 million worth of diamonds anyway?

3. How much money did Overstock actually commit to the diamonds? You said “we paid” $7.2 million, but the 10Q says Overstock loaned the diamond-buying entity $8.4 million. What happened to the extra $1.2 million?

4. You made it sound like you had scoped it out yourself and it was such a great deal…why split the profits? Why not keep all the profits for the benefit of Overstock.com and its shareholders?

5. Why did you say that Overstock could “flip” the diamonds for a $1.3 million profit, when it appears that Overstock would receive only half of any profits from the SPE? Furthermore, 50% of $1.3 million is $650,000, and a $650,000 profit on a $7.2 million diamond purchase is about an 8% gross profit, which is almost half the current 15% gross margin at Overstock.com. How does a deal that is only half as profitable as Overstock’s existing business qualify as the “steal of a lifetime”?

6. Do you or anyone related to you or anyone in management or on the board of Overstock have an interest in this SPE? Who actually owns the equity of the SPE? What equity did they contribute?

7. How did you set the $3 million strike price for the 10-year 50% option…and who were the counterparties to the negotiation?

8. Why did the SPE buy $264,000 worth of PP&E? That’s a lot of furniture for an entity whose sole apparent purpose is “buying inventory,” as per the 10Q. What else did the SPE buy besides the diamonds?

9. If the SPE is not owned by Overstock.com, but supplies the diamonds for the “Build Your Own Jewelry” site on Overstock’s web site, who gets the profits from the diamond sales on the web site? Does the SPE sell the diamonds to Overstock.com at a mark-up?

10. Stepping back and looking at the entire “steal of a lifetime,” the 10Q says your company loaned the SPE $8.4 million to buy inventory. The SPE bought diamonds which, supposedly, you could “flip” for $8.5 million. What’s so great about generating $8.5 million on a capital investment of $8.4 million?

Those are the questions.

Expect no straight answers.

Await the spin on the next conference call.

And beware the Giant Deformed Hedgehogs on Route 80.

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.