The Mystery of the 38 Diamonds, Part II

In The Mystery of the 38 Diamonds, Part I we explored five Overstock.com cases in which events failed to bear out the lofty pronouncements of the company’s erudite, professorial CEO, Patrick Byrne.

For the record, there is nothing inherently wrong with a business that tries new things and makes mistakes. It’s part of what keeps good companies growing. But jumping on fads, trends and ventures that don’t pan out might, after a point, look more like an effort to pump up a stock than a logical plan to rejuvenate a business model.

Today we explore several more Overstock cases, the first up being The Mystery of the Shallow Ocean. In early 2004 word began to spread on Wall Street of a new Overstock “skunkworks” project, labeled “Ocean” by the label-loving Byrne. As one analyst reported:

“Project Ocean is still being kept tightly under wraps but is expected to be disclosed by the end of the summer. The project requires patents to be filed and will cost roughly $1 million.” When the wraps were pulled off “Ocean” it turned out to be an auction site. The timing couldn’t have been better: like most of Byrne’s new ventures that have managed to “super-size” the P/E of Overstock.com shares, “Ocean” road the coat-tails of a very hot trend—online auctions—whose poster-child, eBay, had gained mainstream acceptance as a major transactional platform.

Byrne almost immediately began to spread the big news about Ocean’s strong start:

9/30/04: just giving an idea of how fast this is taking off…since our launch last Friday: …Sometime around 5 A.M. this morning we passed the mark of 4,000 auctions. 66% of completed auctions are clearing (I think eBay is 44%?) He followed up this exuberant first report with a certifiable whopper:

10/22/04: It’s– so far, my belief is, it’s far faster growth than eBay saw in their first 15 days or 20 days. It would be hard to imagine how almost any new auction site—with the aid of $2 million in start-up costs (Byrne’s number) and the availability of Overstock’s existing customer base to jump-start usage—could fail to beat eBay’s “first 15 days or 20 days.”

After all, it took far more than 15 or 20 days for eBay to become a cultural and business phenomenon. Back then, eBay was merely one man’s online marketplace for collectors of Pez dispensers.

Nevertheless, Byrne continued to compare Overstock to eBay—and claim that in some cases Overstock auction was doing a better job than eBay:

1/28/05: [Our auction conversion rate is back] to the 35 to 40 range…. They [eBay] say that they have a closing rate in the 40s…. But if you remember they count it differently than us. …I wouldn’t say we are higher than them but… The eBay power selling community are very sophisticated people and they are doing all kinds of tests and there are certainly areas on our site where they are getting better results than they do on eBay.

Yet, in fact, after a brief surge following eBay’s February fee increase, Overstock’s auction listings stalled out at the 150,000 level and have more or less steadily declined. Listings recently cruised in at a slight 122,000.

A glance at individual categories—antiques, for example—reveals the problem: of the next 100 Overstock antiques auctions to close, only 8 have multiple bids. Thus, the “Ocean” does not appear to be very deep at all.

The Case of the Reappearing Merchandise might be one of the biggest unresolved Overstock mysteries.

Overstock describes itself as an “online ‘closeout’ retailer offering discount, brand-name merchandise”—in other words, “overstocks.” Pretty straightforward. Byrne himself commented on one of the limitations of being a closeout seller early last year:

“We can’t reorder most of the stuff. We just can’t reorder most of it. Almost all of the stuff is not reorderable.” Yet Overstock appears to be doing just that in certain cases.

A “Newport Coffee Table,” for example, was featured in pop-up ads on March 31, thusly:

Almost Sold Out-Act Fast! Newport Coffee Table List $434 Our price $179.99 “Limited Inventory! Sell out Risk: High” Yet that same coffee table re-appeared—in the same “Almost Sold Out” pop-up ad, at the same price—on April 1, 2 and 3. And again a week later.

The strangest thing is that right now—April 13—the very same Newport Coffee Table is still for sale on Overstock, although not identified as a “Sell out Risk.”

Either the “Newport Coffee Table” did not have a high sell out risk as advertised, or product has been reordered. Most likely from Sitcom Furniture.

Who or what is “Sitcom Furniture?” Sitcom manufactures in China:

Sitcom’s fastest growing division is our direct import/private label program. Customers can select items from our current product line to ship directly from the factory either FOB or on a landed basis. We have also developed a number of exclusive products for customers who can sustain long-running container programs, with annual volumes ranging from 2,000 to 24,000 units per item. And “Newport” is one of the furniture lines offered on the Sitcom web site.

If indeed Overstock is importing product manufactured for Overstock, as opposed to surplus furniture manufactured for Ethan Allen or Bombay, it might help explain one other thing besides the Mystery of the Reappearing Merchandise: the dramatic increase in Overstock gross margins over the last year, which Byrne credited to “tightening our logistics costs and better merchandise buying.” Margins on direct imports from China, such as the furniture manufactured by Sitcom, could run far higher than Overstock’s targeted 15% gross margin and help explain the “better merchandise buying.”

A more recent Overstock mystery, The Vanishing Naked Shorts, and its sister case, The Stranger on the Conference Call, are the last to be reviewed here, before we get to the final Mystery of the 38 Diamonds tomorrow.

Sparing the gory technical details that are at least as boring to write as they are to read, Byrne became fixated on the notion that, because shares of Overstock.com appeared on the “SHO Threshold” list, the company was under attack by a pack of “Naked Shorts”—short sellers who fail to correctly borrow stock prior to selling it short.

Naked shorting is illegal, and, as anyone who has been in the investment business longer than two weeks would know, stupid.

But in his most recent earnings call, Byrne allowed an investor, who goes by the name “Bob O’Brien,” to explain at great length how a supposed “Naked Short” attack was being perpetrated on Overstock.com, along with a number of other, lesser companies.

Byrne pretended not to know “O’Brien”:

Byrne (to the operator):

There was a guy, Bob O’Brien.

O’Brien:

Yes, I’m on the line. Thank you for taking my call, Dr. Byrne. Congratulations on a great quarter.

Byrne:

Thank you very much. O’Brien:

You…probably, the name is not familiar. Let me start out by introducing myself. I’m a shareholder, and also a retired guy. I think I can explain what is going on with your stock and, basically, why so many people are saying mean things about you.

Byrne:

I would love to know that.

That little one-act play, in which Byrne and O’Brien pretended not to know each other (“the name is not familiar”), continued with a long, fanciful, and—to anybody who has been in the investment business—absurd tale involving German share listings and all manner of regulatory complicity, which Byrne listened to, and prodded along, with rapt fascination, as if he had never heard it before.

But Byrne indeed knew Mr. O’Brien, for they had spoken shortly after Overstock’s October 2004 conference call.

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Unfortunately for both actors in that play, the lynchpin of their Conspiracy Theory has gone away. Overstock.com shares no longer appear on the on the SHO Threshold list. The Naked Shorts have vanished.

Which leaves one remaining question: why did the CEO of a company pretend on a conference call with investors that he had never heard of or spoken with a man, of whom he had heard and with whom he had spoken?

Why would the answer to this question matter? Well, in the words of Warren Buffett—whom Byrne frequently quotes:

“We also believe candor benefits us as managers: The CEO who misleads others in public may eventually mislead himself in private.” From the Berkshire Owner’s Manual. The Mystery of the 38 Diamonds concludes with Part III, here, tomorrow.

Jeff Matthews I Am Not Making This Up