SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 


 

FORM 10-Q

 

(Mark One)

ý

 

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

 

 

 

 

For the quarterly period ended March 31, 2006

 

 

 

Or

 

 

 

o

 

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

 

 

 

 

For the transition period from                             to                            

 

 

 

Commission file number: 000-49799

 

OVERSTOCK.COM, INC.

(Exact name of registrant as specified in its charter)

 

Delaware

 

87-0634302

(State or other jurisdiction of

 

(I.R.S. Employer

incorporation or organization)

 

Identification Number)

 

6350 South 3000 East

Salt Lake City, Utah 84121

(Address, including zip code, of

Registrant’s principal executive offices)

 

Registrant’s telephone number, including area code: (801) 947-3100

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), (2) has been subject to such filing requirements for the past 90 days.

 

Yes ý  No o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer (as defined in Exchange Act Rule 12b-2 of the Exchange Act).

 

Large accelerated filer o                                                                                     Accelerated filer ý                                                                                          Non-accelerated filer o

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes o                                     ý  No

 

There were 20,513,231 shares of the Registrant’s common stock, par value $0.0001, outstanding on May 5, 2006.

 

 



 

TABLE OF CONTENTS

 

PART I. FINANCIAL INFORMATION

 

 

 

Item 1. Financial Statements (Unaudited)

 

 

 

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

 

 

Item 3. Quantitative and Qualitative Disclosures about Market Risk

 

 

 

Item 4. Controls and Procedures 

 

 

 

PART II. OTHER INFORMATION

 

 

 

Item 1. Legal Proceedings

 

 

 

Item 1A. Risk Factors

 

 

 

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

 

 

 

Item 3. Defaults upon Senior Securities

 

 

 

Item 4. Submission of Matters to a Vote of Security Holders

 

 

 

Item 5. Other Information

 

 

 

Item 6. Exhibits

 

 

 

Signature

 

 

2



 

PART 1. FINANCIAL INFORMATION

 

ITEM 1. FINANCIAL STATEMENTS

 

Overstock.com, Inc.

Consolidated Balance Sheets

(in thousands)

(Unaudited)

 

 

 

December 31,
2005

 

March 31,
2006

 

 

 

 

 

 

 

Assets

 

 

 

 

 

Current assets:

 

 

 

 

 

Cash and cash equivalents

 

$

56,224

 

$

2,618

 

Marketable securities

 

55,799

 

49,220

 

Cash, cash equivalents and marketable securities

 

112,023

 

51,838

 

Accounts receivable, net

 

11,695

 

8,266

 

Inventories, net

 

93,269

 

81,351

 

Prepaid inventory

 

9,633

 

8,839

 

Prepaid expenses

 

8,508

 

10,388

 

 

 

 

 

 

 

Total current assets

 

235,128

 

160,682

 

 

 

 

 

 

 

Restricted cash

 

253

 

55

 

Property and equipment, net

 

63,914

 

66,279

 

Goodwill

 

13,169

 

13,169

 

Other long-term assets, net

 

13,449

 

12,770

 

 

 

 

 

 

 

Total assets

 

$

325,913

 

$

252,955

 

 

 

 

 

 

 

Liabilities, Redeemable Securities and Stockholders’ Equity

 

 

 

 

 

Current liabilities:

 

 

 

 

 

Accounts payable

 

$

101,436

 

$

37,101

 

Accrued liabilities

 

46,847

 

31,167

 

Borrowings

 

 

20,000

 

Capital lease obligations, current

 

6,683

 

5,618

 

 

 

 

 

 

 

Total current liabilities

 

154,966

 

93,886

 

Capital lease obligations, non-current

 

3,058

 

3,969

 

Convertible senior notes

 

74,935

 

75,021

 

 

 

 

 

 

 

Total liabilities

 

232,959

 

172,876

 

 

 

 

 

 

 

Commitments and contingencies (Note 11)

 

 

 

 

 

 

 

 

 

 

 

Redeemable common stock, $0.0001 par value, 446 and 417 shares issued and outstanding as of December 31, 2005 and March 31, 2006

 

3,205

 

2,684

 

 

 

 

 

 

 

Stockholders’ equity:

 

 

 

 

 

Preferred stock, $0.0001 par value, 5,000 shares authorized, no shares issued and outstanding as of December 31, 2005 and March 31, 2006

 

 

 

Common stock, $0.0001 par value, 100,000 shares authorized, 20,571 shares and 20,701 shares issued as of December 31, 2005 and March 31, 2006, respectively

 

2

 

2

 

Additional paid-in capital

 

250,939

 

253,976

 

Accumulated deficit

 

(96,829

)

(112,772

)

Treasury stock, 1,687 and 1,669 shares at cost as of December 31, 2005 and March 31, 2006, respectively

 

(65,325

)

(65,273

)

Accumulated other comprehensive income

 

962

 

1,462

 

 

 

 

 

 

 

Total stockholders’ equity

 

89,749

 

77,395

 

 

 

 

 

 

 

Total liabilities, redeemable securities and stockholders’ equity

 

$

325,913

 

$

252,955

 

 

The accompanying notes are an integral part of these consolidated financial statements.

 

3



 

Overstock.com, Inc.

Consolidated Statements of Operations (unaudited)

(in thousands, except per share data)

 

 

 

Three months ended
March 31,

 

 

 

2005

 

2006

 

 

 

 

 

 

 

Revenue

 

 

 

 

 

Direct

 

$

67,884

 

$

79,710

 

Fulfillment partner

 

97,997

 

100,496

 

 

 

 

 

 

 

Total revenue

 

165,881

 

180,206

 

 

 

 

 

 

 

Cost of goods sold (1):

 

 

 

 

 

Direct

 

58,262

 

70,703

 

Fulfillment partner

 

82,857

 

84,341

 

 

 

 

 

 

 

Total cost of goods sold

 

141,119

 

155,044

 

 

 

 

 

 

 

Gross profit

 

24,762

 

25,162

 

 

 

 

 

 

 

Operating expenses (1):

 

 

 

 

 

Sales and marketing

 

16,826

 

13,177

 

Technology

 

4,099

 

13,589

 

General and administrative

 

7,346

 

13,354

 

 

 

 

 

 

 

Total operating expenses

 

28,271

 

40,120

 

 

 

 

 

 

 

Operating loss

 

(3,509

)

(14,958

)

 

 

 

 

 

 

Interest income

 

644

 

315

 

Interest expense

 

(1,445

)

(1,267

)

 

 

 

 

 

 

Net loss

 

(4,310

)

(15,910

)

Deemed dividend related to redeemable common shares

 

(46

)

(33

)

 

 

 

 

 

 

Net loss attributable to common shares

 

$

(4,356

)

$

(15,943

)

 

 

 

 

 

 

Net loss per common share—basic and diluted

 

$

(0.22

)

$

(0.82

)

Weighted average common shares outstanding—basic and diluted

 

19,862

 

19,385

 

 


(1) Includes stock-based compensation from options as follows:

 

 

 

 

 

Cost of goods sold—direct

 

2

 

96

 

Sales and marketing

 

1

 

70

 

Technology

 

4

 

159

 

General and administrative

 

13

 

633

 

 

 

 

 

 

 

Total stock-based compensation

 

$

20

 

$

958

 

 

The accompanying notes are an integral part of these consolidated financial statements.

 

4



 

Overstock.com, Inc.
Consolidated Statements of Stockholders’ Equity
and Comprehensive Income (unaudited)

 

 

 



Common stock

 

Additional
Paid-in
Capital

 

Accumulated
deficit

 

Treasury stock

 

Accumulated
Other
Comprehensive
Income (loss)

 

Total

 

Shares

 

Amount

Shares

 

Amount

 

 

(amounts in thousands)

 

Balance at December 31, 2005

 

20,571

 

$

2

 

$

250,939

 

$

(96,829

)

(1,687

)

$

(65,325

)

$

962

 

$

89,749

 

Exercise of stock options and warrants

 

101

 

 

1,027

 

 

 

 

 

1,027

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Treasury stock issued to employees as compensation

 

 

 

455

 

 

18

 

52

 

 

507

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Stock-based compensation to consultants in exchange for services

 

 

 

43

 

 

 

 

 

43

 

Stock-based compensation expense from options

 

 

 

958

 

 

 

 

 

958

 

Deemed dividend related to redeemable common stock

 

 

 

 

(33

)

 

 

 

(33

)

Lapse of recission rights on redeemable common stock

 

29

 

 

554

 

 

 

 

 

554

 

Comprehensive income (loss):

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net loss

 

 

 

 

(15,910

)

 

 

 

(15,910

)

Unrealized gain on marketable securities

 

 

 

 

 

 

 

485

 

485

 

Cumulative translation adjustment

 

 

 

 

 

 

 

15

 

15

 

Total comprehensive loss

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

(15,410

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Balance at March 31, 2006

 

20,701

 

$

2

 

$

253,976

 

$

(112,772

)

(1,669

)

$

(65,273

)

$

1,462

 

$

77,395

 

 

The accompanying notes are an integral part of these consolidated financial statements.

 

5



 

Overstock.com, Inc.

Consolidated Statements of Cash Flows (unaudited)

(in thousands)

 

 

 

Three months ended March 31,

 

Twelve months ended March 31,

 

 

 

2005

 

2006

 

2005

 

2006

 

 

 

 

 

 

 

 

 

 

 

Cash flows from operating activities:

 

 

 

 

 

 

 

 

 

Net loss

 

$

(4,310

)

$

(15,910

)

$

(6,597

)

$

(36,518

)

Adjustments to reconcile net loss to net cash provided by (used in) operating activities:

 

 

 

 

 

 

 

 

 

Depreciation and amortization

 

1,635

 

6,835

 

4,816

 

20,814

 

Realized (gain) loss from marketable securities

 

(1

)

(217

)

(3

)

3,135

 

Loss on disposition of property and equipment

 

 

598

 

34

 

2,055

 

Stock-based compensation expense from options

 

20

 

958

 

245

 

1,010

 

Stock options issued to consultants for services

 

(400

)

43

 

598

 

54

 

Issuance of common stock from treasury stock as compensation

 

251

 

507

 

251

 

699

 

Amortization of debt discount and deferred financing fees

 

307

 

139

 

454

 

452

 

Gain from retirement of convertible senior notes

 

 

 

 

(6,158

)

Changes in operating assets and liabilities, net of effect of acquisition:

 

 

 

 

 

 

 

 

 

Accounts receivable, net

 

(752

)

3,429

 

4,732

 

(928

)

Inventories, net

 

(3,570

)

11,918

 

(16,798

)

(31,223

)

Prepaid inventory

 

2,415

 

794

 

(6,697

)

1,068

 

Prepaid expenses

 

(6,302

)

(1,880

)

(8,283

)

(517

)

Other long-term assets, net

 

(614

)

47

 

(172

)

(1,490

)

Accounts payable

 

(24,200

)

(64,335

)

25,275

 

(3,680

)

Accrued liabilities

 

346

 

(15,680

)

13,795

 

7,540

 

 

 

 

 

 

 

 

 

 

 

Net cash provided by (used in) operating activities

 

(35,175

)

(72,754

)

11,650

 

(43,687

)

 

 

 

 

 

 

 

 

 

 

Cash flows from investing activities:

 

 

 

 

 

 

 

 

 

(Increase) decrease in restricted cash

 

590

 

198

 

(1,012

)

957

 

Investments in marketable securities

 

(125,944

)

 

(216,263

)

(59,599

)

Sales of marketable securities

 

59,262

 

7,281

 

73,444

 

164,284

 

Expenditures for property and equipment

 

(13,030

)

(6,845

)

(21,364

)

(38,555

)

Proceeds from sale of property and equipment

 

 

 

20

 

1

 

Acquisition of Ski West (net of cash acquired)

 

 

 

 

(24,620

)

Other investments

 

 

(100

)

 

(100

)

 

 

 

 

 

 

 

 

 

 

Net cash provided by (used in) investing activities

 

(79,122

)

534

 

(165,175

)

42,368

 

 

 

 

 

 

 

 

 

 

 

Cash flows from financing activities:

 

 

 

 

 

 

 

 

 

Payments on capital lease obligations

 

(151

)

(2,428

)

(789

)

(9,363

)

Drawdown on line of credit

 

 

30,728

 

1,000

 

42,596

 

Payoff of line of credit

 

 

(10,728

)

(1,000

)

(22,596

)

Proceeds from issuance convertible senior notes

 

 

 

116,199

 

 

Payments to retire convertible senior notes

 

 

 

 

(35,670

)

Payments of deferred financing fees

 

 

 

(301

)

 

Proceeds from the issuance of common stock

 

 

 

113,064

 

 

Purchase of treasury stock

 

 

 

 

(24,133

)

Purchased call options for purchase of treasury stock

 

(47,507

)

 

(47,507

)

 

Settlement of call options for cash

 

 

 

 

7,937

 

Exercise of stock options

 

906

 

1,027

 

3,027

 

7,436

 

 

 

 

 

 

 

 

 

 

 

Net cash provided by (used in) financing activities

 

(46,752

)

18,599

 

183,693

 

(33,793

)

 

 

 

 

 

 

 

 

 

 

Effect of exchange rate changes on cash

 

(18

)

15

 

5

 

119

 

 

 

 

 

 

 

 

 

 

 

Net decrease in cash and cash equivalents

 

(161,067

)

(53,606

)

30,173

 

(34,993

)

 

 

 

 

 

 

 

 

 

 

Cash and cash equivalents, beginning of period

 

198,678

 

56,224

 

7,438

 

37,611

 

 

 

 

 

 

 

 

 

 

 

Cash and cash equivalents, end of period

 

$

37,611

 

$

2,618

 

$

37,611

 

$

2,618

 

 

 

 

 

 

 

 

 

 

 

Supplemental disclosures of cash flow information:

 

 

 

 

 

 

 

 

 

Interest paid

 

$

586

 

$

278

 

$

735

 

$

4,800

 

Supplemental disclosure of non-cash activities:

 

 

 

 

 

 

 

 

 

Deemed dividend on redeemable common shares

 

$

46

 

$

33

 

$

186

 

$

172

 

Lapse of recission rights

 

$

 

$

554

 

$

 

$

700

 

Equipment and software acquired under capital leases

 

$

15,197

 

$

2,274

 

$

17,012

 

$

2,823

 

Settlement of purchased call options for treasury stock

 

$

 

$

 

$

 

$

41,121

 

 

 

 

 

 

 

 

 

 

 

Fair value of assets acquired, net of cash acquired

 

$

 

$

 

$

 

$

25,956

 

Fair value of liabilities assumed

 

 

 

 

(1,336

)

Cash paid to purchase businesses

 

$

 

$

 

$

 

$

24,620

 

 

The accompanying notes are an integral part of these consolidated financial statements.

 

6



 

Overstock.com, Inc.

Notes to Unaudited Consolidated Financial Statements

 

1. BASIS OF PRESENTATION

 

The accompanying unaudited consolidated financial statements have been prepared by Overstock.com, Inc. (the “Company”) pursuant to the rules and regulations of the Securities and Exchange Commission regarding interim financial reporting. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements and should be read in conjunction with Management’s Discussion and Analysis of Financial Condition and Results of Operations and the audited annual consolidated financial statements and related notes thereto included in the Annual Report on Form 10-K for the year ended December 31, 2005. The accompanying unaudited consolidated financial statements reflect all adjustments, consisting of normal recurring adjustments, which are, in the opinion of management, necessary for a fair statement of results for the interim periods presented. Preparing financial statements requires management to make estimates and assumptions that affect the amounts that are reported in the consolidated financial statements and accompanying disclosures. Although these estimates are based on management’s best knowledge of current events and actions that the Company may undertake in the future, actual results may be different from the estimates. The results of operations for the three months ended March 31, 2006 are not necessarily indicative of the results to be expected for any future period or the full fiscal year.

 

2. ACCOUNTING POLICIES

 

Principles of consolidation

 

The accompanying consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. The consolidated financial statements also include the accounts of a variable interest entity for which the Company is the primary beneficiary (see Note 13). All significant intercompany account balances and transactions have been eliminated in consolidation.

 

Use of estimates

 

The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

 

Internal-Use Software and Website Development

 

Included in fixed assets is the capitalized cost of internal-use software and website development, including software used to upgrade and enhance our websites and processes supporting our business. As required by Statement of Position 98-1, Accounting for the Costs of Computer Software Developed or Obtained for Internal Use, we capitalize costs incurred during the application development stage of internal-use software and amortize these costs over the estimated useful life of three years. Costs incurred related to design or maintenance of internal-use software are expensed as incurred.

 

During the first quarters of 2005 and 2006, the Company capitalized $11.3 million and $8.1 million, respectively, of costs associated with internal-use software and website development, which are partially offset by amortization of previously capitalized amounts of $236,000 and $559,000 for those respective periods.

 

Advertising expense

 

The Company recognizes advertising expenses in accordance with SOP 93-7 Reporting on Advertising Costs. As such, the Company expenses the costs of producing advertisements at the time production occurs or the first time the advertising takes place, and expenses the cost of communicating advertising in the period during which the advertising space or airtime is used. Internet advertising expenses are recognized as incurred based on the terms of the individual agreements, which are generally: 1) during the period customers are acquired; or 2) based on the number of clicks generated during a given period over the term of the contract. Advertising expense included in sales and marketing expenses totaled $16.5 million and $12.5 million during the three months ended March 31, 2005 and 2006, respectively.

 

Stock-based Compensation

 

As of January 1, 2006, we adopted SFAS 123(R) Share-based Payment – an Amendment of FASB Statements No 123 and 95, which requires us to measure compensation expense for all outstanding unvested share-based awards at fair value and recognize compensation expense over the service period for awards expected to vest. The estimation of stock awards that will ultimately vest requires judgment, and to the extent actual results differ from our estimates, such amounts will be recorded as

 

7



 

an adjustment in the period estimates are revised. We consider many factors when estimating expected forfeitures, including types of awards, employee class, and historical experience. Actual results may differ substantially from these estimates (see Note 7).

 

Recent accounting pronouncements

 

In November 2005, the FASB issued FASB Staff Position (“FSP”) Nos. SFAS 115-I and SFAS 124-I, The Meaning of Other-Than-Temporary Impairment and its Application to Certain Investments. This FSP addresses the three-step determination as to when an investment is considered impaired, whether that impairment is other than temporary, and the measurement of an impairment loss. This FSP also includes accounting considerations subsequent to the recognition of an other-than-temporary impairment and requires certain disclosures about unrealized losses that have not been recognized as other-than-temporary impairments. The guidance in this FSP shall be applied to reporting periods beginning after December 15, 2005. The accounting requirements of FSP 115-1 are effective for us on January 1, 2006 and did not have a material impact on our consolidated financial position, results of operations or cash flows.

 

Reclassifications

 

Certain prior year amounts have been reclassified to conform to the current year presentation. The effect of these reclassifications had no impact on net income, total assets, total liabilities, or stockholders’ equity.

 

3. MARKETABLE SECURITIES

 

The Company’s marketable securities consist of Foreign Corporate Securities at March 31, 2006 as follows (in thousands):

 

 

 

Cost Basis

 

Unrealized
Gains

 

Unrealized
Losses

 

Recognized
loss on
Derivative
Security

 

Estimated
Fair Value

 

 

 

 

 

 

 

 

 

 

 

 

 

Foreign corporate securities

 

$

49,937

 

$

1,610

 

$

 

$

(2,327

)

$

49,220

 

 

During the first quarter of 2005, the Company purchased $49.9 million of Foreign Corporate Securities (“Foreign Notes”) which fully mature in November 2006 for $50.0 million in cash . The Foreign Notes do not have a stated interest rate, but are structured to return the entire principal amount and a conditional coupon if held to maturity. The conditional coupon will provide a rate of return dependent on the performance of a “basket” of eight Asian currencies against the U.S. dollar. If the Company redeems the Foreign Notes prior to maturity, the Company may not realize the full amount of its initial investment. At March 31, 2006, the Foreign Notes had a fair value of $49.2 million.

 

Under SFAS No. 133, the Foreign Notes are considered to be derivative financial instruments and are marked to market quarterly. Any unrealized gain or loss related to the changes in value of the conditional coupon is recorded in the income statement as a component of interest income or expense. Any unrealized gain or loss related to the changes in the value of the Foreign Notes is recorded as a component of accumulated other comprehensive income (loss).

 

For the quarter ended March 31, 2006, the combined overall fair value of the Foreign Notes increased $758,000. The increase is attributable to changes in the fair value of the conditional coupon resulting in a gain of $273,000, which is recorded in net income, and changes in fair value of the bond instrument resulting in a gain of $485,000, which is recorded as a component of accumulated other comprehensive income (loss) on the Balance Sheet.

 

The Company purchased the Foreign Notes to manage its foreign currency risks related to the strengthening of Asian currencies compared to the U.S. dollar, which would reduce the inventory purchasing power of the Company in Asia. However, the Company determined that the Foreign Notes did not qualify as hedging derivative instruments. Nevertheless, management believes that such instruments are useful in managing the Company’s associated risk.

 

On April 26, 2006, the Company sold the Foreign Notes for $49.5 million resulting in a total gain on the bond instrument of $1.9 million, comprised of the realization of $1.6 million of unrealized gains and an additional $300,000 gain which the Company will recognize in the second quarter of 2006.

 

The Company had pledged its Foreign Notes as collateral for a $30.0 million revolving line of credit (see Note 9). Subsequent to the sale of the Foreign Notes, the borrowings under the Amended Credit Agreement (see Note 9) are now collateralized by cash balances held at Wells Fargo Bank, National Association.

 

8



 

4. OTHER COMPREHENSIVE LOSS

 

The Company follows SFAS No. 130, Reporting Comprehensive Income. This Statement establishes requirements for reporting comprehensive income and its components. The Company’s comprehensive loss for the three months ended March 31, 2005 and 2006 is as follows (in thousands):

 

 

 

Three months ended
March 31,

 

 

 

2005

 

2006

 

 

 

 

 

 

 

Net loss

 

$

(4,310

)

$

(15,910

)

Unrealized loss on marketable securities

 

(327

)

 

Unrealized gain on Foreign Notes

 

 

485

 

Foreign currency translation adjustment

 

(18

)

15

 

 

 

 

 

 

 

Other comprehensive loss

 

$

(4,655

)

$

(15,410

)

 

5. EARNINGS (LOSS) PER SHARE

 

In accordance with SFAS 128 “Earnings per share”, basic earnings (loss) per share is computed by dividing net income (loss) attributable to common shares by the weighted average number of common shares outstanding during the period. Diluted earnings (loss) per share is computed by dividing net income (loss) attributable to common shares for the period by the weighted average number of common and potential common shares outstanding during the period. Potential common shares, composed of incremental common shares issuable upon the exercise of stock options, warrants and convertible senior notes, are included in the calculation of diluted net loss per share to the extent such shares are dilutive.The following table sets forth the computation of basic and diluted earnings (loss) per share for the periods indicated (in thousands, except per share amounts):

 

 

 

Three months ended March 31,

 

 

 

2005

 

2006

 

Net loss attributable to common shares

 

$

(4,356

)

$

(15,943

)

Weighted average common shares outstanding—basic

 

19,862

 

19,385

 

Effective of dilutive securities:

 

 

 

 

 

Employee stock options and warrants

 

 

 

Convertible senior notes

 

 

 

Weighted average common shares outstanding—diluted

 

19,862

 

19,385

 

Earnings (loss) per common share—basic:

 

$

(0.22

)

$

(0.82

)

Earnings (loss) per common share—diluted:

 

$

(0.22

)

$

(0.82

)

 

The stock options, warrants and convertible senior notes outstanding were not included in the computation of diluted earnings per share because to do so would have been antidilutive. The number of shares of stock options outstanding at each quarter-end was 1,468,000 shares and 1,181,000 shares for 2005 and 2006, respectively. There were 863,000 warrants outstanding at March 31, 2005. No warrants were outstanding at March 31, 2006. As of March 31, 2006, the Company had $75.0 million of convertible senior notes outstanding, which could potentially convert into 1,010,000 shares of common stock in the aggregate.

 

6. BUSINESS SEGMENTS

 

Segment information has been prepared in accordance with SFAS No. 131, Disclosures about Segments of an Enterprise and Related Information. Segments were determined based on products and services provided by each segment. There were no inter-segment sales or transfers during the three-month periods ended March 31, 2005 or 2006. The Company evaluates the performance of its segments and allocates resources to them based primarily on gross profit. The table below summarizes information about reportable segments for the three months ended March 31, 2005 and 2006 (in thousands):

 

9



 

 

 

Three months ended March 31,

 

 

 

Direct 
operations

 

Fulfillment
partner
operations

 

Consolidated

 

2005

 

 

 

 

 

 

 

Revenue

 

$

67,884

 

$

97,997

 

$

165,881

 

Cost of goods sold

 

58,262

 

82,857

 

141,119

 

 

 

 

 

 

 

 

 

Gross profit

 

$

9,622

 

$

15,140

 

24,762

 

Operating expenses

 

 

 

 

 

(28,271

)

Other income (expense), net

 

 

 

 

 

(801

)

 

 

 

 

 

 

 

 

Net loss

 

 

 

 

 

$

(4,310

)

 

 

 

 

 

 

 

 

2006

 

 

 

 

 

 

 

Revenue

 

$

79,710

 

$

100,496

 

$

180,206

 

Cost of goods sold

 

70,703

 

84,341

 

155,044

 

 

 

 

 

 

 

 

 

Gross profit

 

$

9,007

 

$

16,155

 

25,162

 

Operating expenses

 

 

 

 

 

(40,120

)

Other income (expense), net

 

 

 

 

 

(952

)

 

 

 

 

 

 

 

 

Net loss

 

 

 

 

 

$

(15,910

)

 

The direct segment includes revenues, direct costs, and allocations associated with sales fulfilled from our warehouse. Costs for this segment include product costs, inbound and outbound freight, warehousing and fulfillment costs, credit card fees and customer service costs.

 

The fulfillment partner segment includes revenues, direct costs and cost allocations associated with the Company’s third party fulfillment partner sales and are earned from selling the merchandise of third parties over the Company’s Websites. The costs for this segment include product costs, warehousing and fulfillment costs, credit card fees and customer service costs.

 

Assets have not been allocated between the segments for management purposes, and as such, they are not presented here.

 

For the quarters ended March 31, 2005 and 2006, over 99% of sales were made to customers in the United States of America. No individual geographical area within the U.S accounted for more than 10% of net sales in any of the periods presented. At December 31, 2005 and March 31, 2006, all of the Company’s fixed assets were located in the United States of America.

 

7. STOCK-BASED COMPENSATION

 

Periods prior to the adoption of SFAS 123(R)

 

Prior to January 1, 2006, the Company accounted for stock-based awards under the intrinsic value method, which followed the recognition and measurement principles of APB Opinion No. 25, Accounting for Stock Issued to Employees , and related interpretations. The intrinsic value method of accounting resulted in compensation expense for for stock options to the extent option exercise prices were set below market prices on the date of grant. Also, to the extent stock awards were forfeited prior to vesting, the previously recognized expense was reversed as an offset to operating expenses.

 

The following table illustrates the effects on net loss and net loss per share as if the Company had applied the fair value recognition provisions of SFAS 123, Accounting for Stock Based Compensation , as amended by SFAS No. 148, Accounting for Stock-Based Compensation — Transition and Disclosure to options granted under the Company’s stock-based compensation plans prior to the adoption. For purposes of this pro forma disclosure, the value of the options was estimated using the Black-Scholes-Merton (“BSM”) option-pricing formula and amortized on a straight-line basis over the respective vesting periods of the awards. Disclosures for the three months ended March 31, 2006 are not presented because stock-based payments were accounted for under SFAS 123(R)’s fair value method during this period.

 

10



 

(in thousands, except per share amounts)

 

Three months
ended March 31,
2005

 

 

 

 

 

Net loss, as reported

 

$

(4,310

)

 

 

 

 

Add:  Stock-based compensation, as reported

 

20

 

 

 

 

 

Deduct:  Total stock-based compensation expense determined using SFAS 123(R) fair value based method for all awards

 

(904

)

 

 

 

 

Pro forma net loss – SFAS 123 fair value adjusted

 

$

(5,194

)

 

 

 

 

Net loss per common share

 

 

 

Basic and diluted—as reported

 

$

(0.22

)

Basic and diluted—pro forma

 

$

(0.26

)

 

Adoption of SFAS 123(R)

 

As of January 1, 2006, the Company adopted SFAS No. 123(R) using the modified prospective method, which requires measurement of compensation cost for all stock-based awards at fair value on date of grant and recognition of compensation over the service period for awards expected to vest. The fair value of stock options is determined using the BSM valuation model, which is consistent with our valuation techniques previously utilized for options in footnote disclosures required under SFAS No. 123. Such value is recognized as expense over the service period, net of estimated forfeitures, using the straight-line method under SFAS 123(R).

 

The adoption of SFAS 123(R) did not result in a cumulative benefit from accounting change, which reflects the net cumulative impact of estimating future forfeitures in the determination of period expense, rather than recording forfeitures when they occur as previously permitted, as we did not have unvested employee stock awards for which compensation expense was recognized prior to adoption of SFAS No. 123(R).

 

Prior to the adoption of SFAS 123(R), cash retained as a result of tax deductions relating to stock-based compensation was presented in operating cash flows, along with other tax cash flows, in accordance with the provisions of the Emerging Issues Task Force (“EITF”) Issue No. 00-15, Classification in the Statement of Cash Flows of the Income Tax Benefit Received by a Company upon Exercise of a Nonqualified Employee Stock Option. SFAS 123(R) supersedes EITF 00-15, amends SFAS 95, Statement of Cash Flows, and requires tax benefits relating to excess stock-based compensation deductions to be prospectively presented in the statement of cash flows as financing cash inflows. As of the adoption of SFAS 123(R), we had fully reserved against any tax benefits resulting from stock-based compensation deductions in excess of amounts reported for financial reporting purposes.

 

On March 29, 2005, the SEC published Staff Accounting Bulletin (“SAB”) No. 107, which provides the Staff’s views on a variety of matters relating to stock-based payments. SAB 107 requires stock-based compensation be classified in the same expense line items as cash compensation. The Company has reclassified stock-based compensation from prior periods to correspond to current period presentation within the same operating expense line items as cash compensation paid to employees.

 

The application of SFAS 123(R) had the following effect on the first quarter of March 31, 2006 reported amounts relative to amounts that would have been reported using the intrinsic value method under previous accounting (in thousands, except per share amounts):

 

 

 

SFAS 123(R)
Adjustments

 

 

 

 

 

Operating loss

 

$

(958

)

Net loss

 

$

(958

)

 

 

 

 

Net loss per common share – basic and diluted

 

$

(0.05

)

 

Valuation Assumptions for Stock Options

 

During the first quarter of 2006, 13,000 options were granted to employees with an estimated total grant-date fair value of $201,000. Of this amount, the Company estimated that the stock-based compensation for the awards not expected to vest was $52,000. During the three months ended March 31, 2006, the Company recorded stock-based compensation related to stock options of $958,000 for all unvested options granted prior and after the adoption of SFAS 123(R).

 

11



 

The fair value for each stock option granted during the first quarter of 2005 and 2006 was estimated at the date of grant using the BSM option-pricing model, assuming no dividends and the following assumptions.

 

 

 

Three months ended
March 31,

 

 

 

2005

 

2006

 

 

 

 

 

 

 

Average risk-free interest rate

 

3.96

%

4.84

%

Average expected life (in years)

 

3.0

 

3.5

 

Volatility

 

95.0

%

86.4

%

 

Expected Volatility:  The fair value of stock based payments were valued using a volatility factor based on the Company’s historical stock prices.

 

Expected Term:  The Company’s expected term represents the period that the Company’s stock-based awards are expected to be outstanding and was determined based on historical experience of similar awards, giving consideration to the contractual terms and vesting provisions of the stock-based awards.

 

Expected Dividend:  The Company has not paid any dividends and does not anticipate paying dividends in the foreseeable future.

 

Risk-Free Interest Rate:   The Company bases the risk-free interest rate used on the implied yield currently available on U.S. Treasury zero-coupon issues with remaining term equivalent to the expected term of the options.

 

Estimated Pre-vesting Forfeitures:  When estimating forfeitures, the Company considers voluntary and involuntary termination behavior.

 

Stock Option Activity

 

The Company’s board of directors adopted the Amended and Restated 1999 Stock Option Plan, the 2002 Stock Option Plan and the 2005 Equity Incentive Plan (collectively, the “Plans”), in May 1999, April 2002, and April 2005 respectively. Under these Plans, the Board of Directors may issue incentive stock options to employees and directors of the Company and non-qualified stock options to consultants of the Company. Options granted under these Plans generally expire at the end of five years and vest in accordance with a vesting schedule determined by the Company’s Board of Directors, usually over four years from the grant date. As of the initial public offering, the Amended and Restated 1999 Stock Option Plan was terminated, and as of April 2005 the 2002 Stock Option Plan was terminated (except with regard to outstanding options). Future shares will be granted under the 2005 Equity Incentive Plan. As of March 31, 2006, 1,117,000 shares are available for future grants under the 2005 Equity Incentive Plan. The Company settles stock option exercises with newly issued common shares.

 

The following is a summary of stock option activity (in thousands, except per share data):

 

 

 

Shares

 

Weighted
Average
Exercise
Price

 

Outstanding—beginning of year

 

1,299

 

$

18.09

 

Granted

 

13

 

24.61

 

Exercised

 

(101

)

9.30

 

Forfeited

 

(30

)

15.70

 

Outstanding at March 31, 2006

 

1,181

 

18.97

 

 

 

 

 

 

 

Options exercisable at year-end

 

716

 

13.44

 

 

12



 

The following table summarizes information about stock options as of March 31, 2006 (in thousands, except per share data):

 

 

 

Options Outstanding

 

Options Exercisable

 

Range of Exercise Prices

 

Shares

 

Weighted
Average
Exercise
Price

 

Weighted
Average
Remaining
Contract
Life

 

Aggregate
Intrinsic
Value

 

Shares

 

Weighted
Average
Exercise
Price

 

Weighted
Average
Remaining
Contract
Life

 

Aggregate
Intrinsic
Value

 

$2.00-$4.99

 

76

 

$

4.37

 

1.31

 

$

1,646

 

67

 

$

4.29

 

1.27

 

$

1,441

 

$ 5.00-$6.99

 

227

 

5.07

 

0.79

 

4,724

 

227

 

5.07

 

0.79

 

4,724

 

$7.00-$11.99

 

78

 

10.66

 

1.44

 

1,195

 

66

 

11.02

 

1.33

 

991

 

$12.00-$17.99

 

264

 

13.23

 

2.31

 

3,357

 

161

 

13.28

 

2.27

 

2,031

 

$18.00-$58.30

 

536

 

30.96

 

3.38

 

1,792

 

196

 

27.17

 

3.03

 

926

 

 

 

1,181

 

18.97

 

2.38

 

12,713

 

716

 

13.44

 

1.83

 

10,111

 

 

Total compensation costs related to nonvested awards was approximately $7.1 million as of March 31, 2006. These nonvested awards are expected to be exercised over the weighted average period of 2.38 years.

 

The aggregate intrinsic value in the table above represents the total pretax intrinsic value, based on the Company’s average stock price of $25.93 during the quarter ended March 31, 2006, which would have been received by the option holders had all option holders exercised their options as of that date. The total number of in-the-money options exercisable as of March 31, 2006 was 646,000.

 

The weighted average exercise price of options granted during the three months ended March 31, 2006 was $24.61 per share. The total fair value of the shares vested during the three months ended March 31, 2006 was $1.4 million. The total intrinsic value of options exercised during the three month period ended March 31, 2006 was $1.7 million. The total cash received from employees as a result of employee stock option exercises during the three months ended March 31, 2006 was approximately $1.0 million. In connection with these exercises, there was no tax benefit realized by the Company due to the Company’s current loss position.

 

8. PERFORMANCE SHARE PLAN

 

In January 2006, the Board and Compensation Committee adopted the Overstock.com Performance Share Plan, and approved grants to executive officers and certain employees of the Company. The Performance Share Plan provides for a three-year period for the measurement of the Company’s attainment of the performance goal described in the form of grant, but at the Company’s sole option the Company may make a payment of estimated amounts payable to a plan participant after two years.

 

The performance goal is measured by growth in economic value, as defined in the plan. The amount of payments due to participants under the plan will be a function of the then current market price of a share of the Company’s common stock, multiplied by a percentage dependent on the extent to which the performance goal has been attained, which will be between 0% and 200%. If the growth in economic value is 10% compounded annually or less, the percentage will be 0%. If the growth in economic value is 25% compounded annually, the percentage will be 100%. If the growth in economic value is 40% compounded annually or more, the percentage will be 200%. If the percentage growth is between these percentages, the payment percentage will be determined on the basis of straight line interpolation. Amounts payable under the plan will be payable in cash. During interim and annual.periods prior to the completion of the three-year measurement period, the Company must record compensation expense based upon the period-end stock price and estimates regarding the ultimate growth in economic value that is expected to occur. These estimates include assumed future growth rates in revenues, gross margins and other factors. If the Company were to use different assumptions, the estimated compensation charges could be significantly different.

 

As of March 31, 2006, the Company has accrued approximately $400,000 in compensation expense under the plan.

 

9. BORROWINGS

 

$30.0 million Amended Credit Agreement

 

On October 18, 2005, the Company entered into a sixth amendment to a credit agreement (“Amended Credit Agreement”) with Wells Fargo Bank, National Association. The Amended Credit Agreement provides a revolving line of credit to the Company of up to $30.0 million which the Company uses primarily to obtain letters of credit to support inventory purchases. The Amended Credit Agreement expires on December 31, 2007, however, the Company has an option to renew the Amended Credit Agreement annually. Interest on borrowings is payable monthly and accrued at either (i) 1.35% above LIBOR in effect on the first day of an applicable fixed rate term, or (ii) at a fluctuating rate per annum determined by the bank to be one half a percent (0.50%) above daily LIBOR in effect on each business day a change in daily LIBOR is announced by the bank. Unpaid principal, together with accrued and unpaid interest is due on the maturity date. The

 

13



 

Amended Credit Agreement requires the Company to comply with certain covenants, including restrictions on mergers, business combinations or transfer of assets. The Company was in compliance with these covenants at March 31, 2006.

 

At March 31, 2006, borrowings under the Amended Credit Agreement were collateralized by the Company’s Foreign Notes, which had an aggregate principal amount of $50.0 million. On April 26, 2006, the Company sold the Foreign Notes and borrowings under the Amended Credit Agreement are now collateralized by cash balances held at Wells Fargo Bank, National Association.

 

At March 31, 2006, no amounts were outstanding under the Amended Credit Agreement, and Letters of Credit totaling $13.1 million were issued on behalf of the Company.

 

$40.0 million WFRF Agreement

 

On December 12, 2005, the Company entered into a Loan and Security Agreement (the “WFRF Agreement”) with Wells Fargo Retail Finance, LLC and related security agreements and other agreements described in the WFRF Agreement.

 

The WFRF Agreement provides for advances to the Company and for the issuance of letters of credit for its account of up to an aggregate maximum of $40.0 million. The Company has the right to increase the aggregate maximum amount available under the facility to up to $50.0 million during the first two years of the facility. The amount actually available to the Company may be less and may vary from time to time, depending on, among other factors, the amount of its eligible inventory and receivables. The Company’s obligations under the WFRF Agreement and all related agreements are collateralized by all or substantially all of the Company’s and its subsidiaries’ assets. The Company’s obligations under the WFRF Agreement are cross-collateralized with its assets pledged under its $30.0 million credit facility with Wells Fargo Bank, National Association. The term of the WFRF Agreement is three years, expiring on December 12, 2008. The WFRF Agreement contains standard default provisions.

 

Advances under the WFRF Agreement bear interest at either (a) the rate announced, from time to time, within Wells Fargo Bank, National Association at its principal office in San Francisco as its “prime rate” or (b) a rate based on LIBOR plus a varying percentage between 1.25% and 1.75%; however, the annual interest rate on advances under the WFRF Agreement will be at least 3.50%. The WFRF Agreement includes affirmative covenants as well as negative covenants that prohibit a variety of actions without the lender’s approval, including covenants that limit the Company’s ability to (a) incur or guarantee debt, (b) create liens, (c) enter into any merger, recapitalization or similar transaction or purchase all or substantially all of the assets or stock of another person, (d) sell assets, (e) change its name or the name of any of its subsidiaries, (f) make certain changes to its business, (g) optionally prepay, acquire or refinance indebtedness, (h) consign inventory, (i) pay dividends on, or purchase, acquire or redeem shares of, its capital stock, (j) change its method of accounting, (k) make investments, (l) enter into transactions with affiliates, or (m) store any of its inventory or equipment with third parties. The Company was in compliance with these covenants as of March 31, 2006.

 

At March 31, 2006, the Company had $20.0 million of borrowings on the WFRF Agreement.

 

Capital leases

 

The Company leases certain software and computer equipment under three non-cancelable capital leases that expire at various dates through 2008. Software and equipment acquired relating to the capital leases totaled $15.4 million and $17.7 million at December 31, 2005 and March 31, 2006, respectively, with accumulated amortization of $10.1 and $11.0 million at those respective dates. Depreciation of assets recorded under capital leases was $553,000 and $1.5 million for the quarters ended March 31, 2005 and 2006, respectively.

 

Future minimum lease payments under capital leases are as follows (in thousands):

 

Twelve Months Ending March 31,

 

 

 

2007

 

$

5,654

 

2008

 

3,967

 

2009

 

2

 

Total minimum lease payments

 

9,623

 

Less: amount representing interest

 

(36

)

Present value of capital lease obligations

 

9,587

 

Less: current portion

 

(5,618

)

Capital lease obligations, non-current

 

$

3,969

 

 

14



 

10.  3.75% CONVERTIBLE SENIOR NOTES

 

In November 2004, the Company completed an offering of $120.0 million of 3.75% Convertible Senior Notes (the “Senior Notes”). Proceeds to the Company were $116.2 million, net of $3.8 million of initial purchaser’s discount and debt issuance costs. The discount and debt issuance costs are being amortized using the straight-line method which approximates the interest method. During the first quarters of 2004 and 2005, the Company recorded amortization of discount and debt issuance costs related to this offering totaling $0 and $139,000. Interest on the Senior Notes is payable semi-annually on June 1 and December 1 of each year. The Senior Notes mature on December 1, 2011 and are unsecured and rank equally in right of payment with all existing and future unsecured, unsubordinated debt and senior in right of payment to any existing and future subordinated indebtedness.

 

The Senior Notes are convertible at any time prior to maturity into the Company’s common stock at the option of the note holders at a conversion price of $76.23 per share or, originally approximately 1.6 million shares in aggregate (subject to adjustment in certain events, including stock splits, dividends and other distributions and certain repurchases of the Company’s stock, as well as certain fundamental changes in the ownership of the Company). Beginning December 1, 2009, the Company has the right to redeem the Senior Notes, in whole or in part, for cash at 100% of the principal amount plus accrued and unpaid interest. Upon the occurrence of a fundamental change (including the acquisition of a majority interest in the Company, certain changes in the Company’s board of directors or the termination of trading of the Company’s stock) meeting certain conditions, holders of the Senior Notes may require the Company to repurchase for cash all or part of their notes at 100% of the principal amount plus accrued and unpaid interest.

 

The indenture governing the Senior Notes requires the Company to comply with certain affirmative covenants, including making principal and interest payments when due, maintaining our corporate existence and properties, and paying taxes and other claims in a timely manner. The Company was in compliance with these covenants at March 31, 2006.

 

In June and November 2005, the Company retired $33.0 million and $10.0 million of the Senior Notes for $27.9 million and $7.8 million in cash for each respective retirement. As a result of the note retirements in June and November, the Company recognized a gain of $6.2 million, net of the associated unamortized discount of $1.2 million for the year ended December 31, 2005. As of March 31, 2006, $77.0 million of the Senior Notes remained outstanding.

 

11.  COMMITMENTS AND CONTINGENCIES

 

Commitments

 

The Company began leasing approximately 154,000 rentable square feet for a term of ten years beginning July 2005. In February 2005, the Company and Old Mill Corporate Center III, LLC (the “Lessor”) entered into a Tenant Improvement Agreement (the “OMIII Agreement”) relating to the office building. The OMIII Agreement sets forth the terms on which the Company will pay the costs of certain improvements to the leased office space. The amount of the costs is estimated to be approximately $2.0 million. The OMIII Agreement requires the Company to reimburse the Lessor for the amount of the costs within thirty days after presentation of invoices or written requests for reimbursement. The OMIII Agreement also requires the Company to provide either a cash deposit or a letter of credit in the amount of $500,000 to the Lessor to provide funds for the removal of the improvements upon the termination of the lease. The Company’s bank issued a letter of credit for $500,000 to the Lessor on behalf of the Company.

 

The Company leases 480,000 square feet for its warehouse facilities in Utah under operating leases which expire in August 2012.

 

In June 2005, the Company entered into a non-cancelable operating lease for certain computer equipment expiring in the next three years. It is expected that such leases will be renewed by exercising purchase options or replaced by leases of other computer equipment.

 

Minimum future payments under these leases are as follows (in thousands):

 

Twelve months ended March 31,

 

 

 

2007

 

$

7,639

 

2008

 

6,851

 

2009

 

7,396

 

2010

 

8,491

 

2011

 

7,961

 

Thereafter

 

33,616

 

 

 

$

71,954

 

 

15



 

Rental expense for operating leases totaled $644,000 and $1.3 million for the quarters ended March 31, 2005 and 2006, respectively.

 

Legal Proceedings

 

From time to time, we receive claims of and become subject to consumer protection, employment, intellectual property and other commercial litigation related to the conduct of our business. Such litigation could be costly and time consuming and could divert our management and key personnel from our business operations. The uncertainty of litigation increases these risks. In connection with such litigation, we may be subject to significant damages or equitable remedies relating to the operation of our business and the sale of products on our websites. Any such litigation may materially harm our business, prospects, results of operations, financial condition or cash flows. However, we do not currently believe that any of our outstanding litigation will have a material adverse effect on our financial statements.

 

In October 2003, Tiffany (NJ) Inc. and Tiffany and Company filed a complaint against us in the United States District Court for the Southern District of New York alleging that we have distributed counterfeit and otherwise unauthorized Tiffany product in violation of federal copyright and trademark law and related state laws. The complaint seeks statutory and other damages in an unspecified amount and injunctive relief. In January and February 2005, Tiffany (NJ) Inc. and Tiffany and Company filed five additional complaints against us in the United States District Court for the Southern District of New York alleging that we have distributed counterfeit and otherwise unauthorized Tiffany product in violation of federal copyright and trademark law and related state laws. We have recently reached an agreement in principle that will settle and dismiss all of the cases. We are currently working on a definitive settlement agreement with Tiffany.

 

In September 2004, we received a letter from BTG International Inc. claiming that certain of our business practices and online marketing information technology systems infringe patents owned by BTG. On September 14, 2004, without engaging in any meaningful discussion or negotiation with us, BTG filed a complaint in the United States District Court of Delaware alleging that certain of our business practices and online marketing information technology systems infringe a single patent owned by BTG. On October 21, 2004, we filed an answer denying the material allegations in BTG’s claims. We have recently reached an agreement in principle that will settle and dismiss the case. We are currently working on a definitive settlement agreement with BTG.

 

In December 2003, we received a letter from Furnace Brook claiming that certain of our business practices and our on-line ordering system infringe a single patent owned by Furnace Brook. After diligent efforts to show that we do not infringe the patent and Furnace Brook’s continual demands that we enter into licensing arrangements with respect to the asserted patent, on August 12, 2005, we filed a complaint in the United States District Court of Utah, Central Division, seeking declaratory judgment that we do not infringe any valid claim of the Furnace Brook patent. Furnace Brook filed a motion to dismiss our complaint for lack of personal jurisdiction over Furnace Brook in Utah. On October 31, 2005, the United States District Court of Utah, Central Division, issued a decision to dismiss our complaint for lack of personal jurisdiction over Furnace Brook. On December 14, 2005, we filed an appeal of the Utah decision with the United States Court of Appeals for the Federal Circuit. On August 18, 2005, shortly after we filed the complaint in Utah, Furnace Brook filed a complaint in the United States District Court for the Southern District of New York, alleging that certain of our business practices and our on-line ordering system infringe a single patent owned by Furnace Brook. On September 9, 2005, we filed an answer denying the material allegations in Furnance Brook’s claims. Although we have filed an answer and believe we have defenses to the allegations and intend to pursue them vigorously, the Furnace Brook lawsuit is in the discovery stage, and we do not have sufficient information to assess the probability of success or the amount of potential damages.

 

On August 11, 2005, along with a shareholder plaintiff, we filed a complaint against Gradient Analytics, Inc.; Rocker Partners, LP; Rocker Management, LLC; Rocker Offshore Management Company, Inc. and their respective principals. We, along with a second shareholder plaintiff, filed the complaint in the Superior Court of California, County of Marin. On October 12, 2005, we filed an amended complaint against the same entities alleging libel, intentional interference with prospective economic advantage and violations of California’s unfair business practices act. On March 7, 2006, the court denied the defendants demurrers to and motions to strike the amended complaint. The defendants have each filed a motion to appeal the court’s decision; the court has ruled that this appeal stays discovery in the case. We intend to pursue this action vigorously.

 

On May 9, 2006 the Company received a notice of an investigation and subpoena from the Securities and Exchange Commission, Salt Lake City District Office.  The subpoena requests a broad range of documents, including, among other documents, all documents relating to the Company’s accounting policies, the Company’s targets, projections or estimates related to financial performance, the Company’s recent restatement of its financial statements, the filing of its complaint against Gradient Analytics, Inc., the development and implementation of certain new technology systems and disclosures of progress and problems with those systems, communications with and regarding investment analysts, communications regarding shareholders who did not receive the Company’s proxy statement in April 2006, communications with certain shareholders, and communications regarding short selling, naked short selling, purchases and sales of Company stock, obtaining paper certificates, and stock loan or borrow of Company shares. The Company intends to review the subpoena and respond in due course.

 

12. INDEMNIFICATIONS AND GUARANTEES

 

During its normal course of business, the Company has made certain indemnities, commitments, and guarantees under which it may be required to make payments in relation to certain transactions. These indemnities include, but are not limited to, indemnities to various lessors in connection with facility leases for certain claims arising from such facility or lease, and indemnities to directors and officers of the Company to the maximum extent permitted under the laws of the State of Delaware. The duration of these indemnities, commitments, and guarantees varies, and in certain cases, is indefinite. In

 

16



 

addition, the majority of these indemnities, commitments, and guarantees do not provide for any limitation of the maximum potential future payments the Company could be obligated to make. As such, the Company is unable to estimate with any reasonableness its potential exposure under these items. The Company has not recorded any liability for these indemnities, commitments, and guarantees in the accompanying consolidated balance sheets. The Company does, however, accrue for losses for any known contingent liability, including those that may arise from indemnification provisions, when future payment is both probable and reasonably estimable. The Company carries specific and general liability insurance policies that the Company believes would, in most circumstances, provide some, if not total coverage for any claims arising from these indemnifications.

 

13. VARIABLE INTEREST ENTITY

 

In August 2004, the Company entered into an agreement which allows the Company to lend up to $10.0 million to an entity for the purpose of buying diamonds and other jewelry, primarily to supply a new category within our jewelry store which allows customers purchasing diamond rings to select both a specific diamond and ring setting. In November 2004, the Company loaned the entity $8.4 million. The promissory note bears interest at 3.75% per annum. In addition, the Company receives fifty percent (50%) of any profits of the entity. Interest on the loan is due and payable quarterly on the fifteenth day of February, May, August and November, commencing on November 15, 2004 until the due date of November 30, 2006, on which all principal and interest accrued and unpaid thereon, shall be due and payable. The promissory note is collateralized by all of the assets of the entity.

 

The Company has a ten year option to purchase (“Purchase Option”) 50% of the ownership and voting interest of the entity. The exercise price of the Purchase Option is the sum of (a) one thousand dollars, and (b) $3.0 million, which may be paid, at the Company’s election, in cash or by the forgiveness of $3.0 million of the entity’s indebtedness to the Company.

 

The entity was evaluated in accordance with FASB Interpretation No. 46 Revised, Consolidation of Variable Interest Entities—an Interpretation of ARB No. 51, and it was determined to be a variable interest entity for which the Company was determined to be the primary beneficiary. As such, the financial statements of the entity are consolidated into the financial statements of the Company.

 

The carrying amount and classification of the consolidated assets that are collateral for the entity’s obligations include (in thousands):

 

 

 

March 31,
2006

 

Cash

 

$

321

 

Accounts receivable

 

87

 

Inventory

 

7,282

 

Prepaid expenses

 

32

 

Property and equipment

 

210

 

 

 

$

7,932

 

 

During the first quarter of 2006, the Company temporarily removed the functionality for its customers to design jewelry from its Website, and therefore the entity plans to sell its inventory through other sales channels.

 

14. SUBSEQUENT EVENTS

 

On April 26, 2006, the Company sold the Foreign Notes for $49.5 million resulting in a total gain on the bond instrument of $1.9 million, comprised of the realization of $1.6 million of unrealized gains and an additional $300,000 of recognized gain which the Company will record in the second quarter of 2006. As a result, the Company’s obligations under the Amended Credit Agreement are now secured by its cash deposits with Wells Fargo.

 

On May 1, 2006, the Company sold approximately 1.0 million shares of common stock for an aggregate price of $25.0 million. On May 8, 2006, the Company agreed to sell an additional 700,000 shares of common stock for an aggregate price of $16.8 million. On May 9, 2006 the Company offered to terminate this purchase agreement, and on May 10, 2006 the purchaser elected to do so.

 

On May 9, 2006 the Company received a notice of an investigation and subpoena from the Securities and Exchange Commission, Salt Lake City District Office.  The subpoena requests a broad range of documents, including, among other documents, all documents relating to the Company’s accounting policies, the Company’s targets, projections or estimates related to financial performance, the Company’s recent restatement of its financial statements, the filing of its complaint against Gradient Analytics, Inc., the development and implementation of certain new technology systems and disclosures of progress and problems with those systems, communications with and regarding investment analysts, communications regarding shareholders who did not receive the Company’s proxy statement in April 2006, communications with certain shareholders, and communications regarding short selling, naked short selling, purchases and sales of Company stock, obtaining paper certificates, and stock loan or borrow of Company shares. The Company intends to review the subpoena and respond in due course.

 

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ITEM 2.   MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

In addition to historical information, this Quarterly Report on Form 10–Q contains forward-looking statements. These statements relate to our, and in some cases our customers’ or other third parties’, future plans, objectives, expectations, intentions and financial performance and the assumptions that underlie these statements. These forward-looking statements include, but are not limited to, statements regarding the following: our beliefs and expectations regarding the seasonality of our direct and fulfillment partner revenue; our beliefs regarding the sufficiency of our capital resources; planned distribution and order fulfillment capabilities; our beliefs, intentions and expectations regarding improvements of our order processing systems and capabilities; our intentions regarding the development of enhanced technologies and features; our intentions regarding the expansion of our customer service capabilities; our belief and intentions regarding improvements to our general and administrative functions; our beliefs and intentions regarding enhancements to our sales and marketing activities; our beliefs regarding the potential for growth in our customer base; our beliefs and intentions regarding our expansion into new markets, including international markets; our beliefs and intentions about entering into agreements to provide products and services to retail chains and other businesses; our belief regarding potential development of new Websites; our beliefs, intentions and expectations regarding promotion of new or complimentary product and sales formats; our belief, intentions and expectations regarding the expansion of our product and service offerings; our beliefs and intentions regarding expanding our market presence through relationships with third parties; our beliefs regarding the pursuit of complimentary businesses and technologies; our beliefs regarding the adequacy of our insurance coverage; our beliefs, intentions and expectations regarding litigation matters and legal proceedings, our defenses to such matters and our contesting of such matters; our beliefs and expectations regarding our existing cash and cash equivalents, cash requirements and sufficiency of capital; and our beliefs and expectations regarding interest rate risk, our investment activities and the effect of changes in interest rates.

 

These forward-looking statements are subject to risks and uncertainties that could cause actual results and events to differ materially. For a detailed discussion of these risks and uncertainties please see Item 1A – Risk Factors and the description of risk factors set forth in our Annual Report on Form 10-K for the year ended December 31, 2005. These forward-looking statements speak only as of the date of this report and, except as required by law, we undertake no obligation to update forward-looking statements to reflect events or circumstances occurring after the date of this report.

 

Overview

 

We are an online “closeout” retailer offering discount brand name merchandise, including bed-and-bath goods, home décor, kitchenware, watches, jewelry, electronics and computers, sporting goods, apparel, designer accessories and limited travel services, among other products. We also sell books, magazines, CDs, DVDs, videocassettes and video games (“BMVG”), and we operate as part of our Website an online auction site—a marketplace for the buying and selling of goods—between our customers. Our Website includes five main tabs: Shopping; Books, Music, Movies and Games; Bulk Buys & Business Supplies; Auctions; and Travel.

 

Our company, based in Salt Lake City, Utah, was founded in 1997, and we launched our first Website through which customers could purchase products in March 1999. Our Websites offer our customers an opportunity to shop for bargains conveniently, while offering our suppliers an alternative inventory liquidation distribution channel. We continually add new, limited inventory products to our Websites in order to create an atmosphere that encourages customers to visit frequently and purchase products before our inventory sells out. In eight departments under the Shopping tab on our main Website, www.overstock.com, we offer approximately 62,000 products on our shopping tab and approximately 725,000 products on our BMVG tab.

 

Closeout merchandise is typically available in inconsistent quantities and prices and often is only available to consumers after it has been purchased and resold by disparate liquidation wholesalers. We believe that the traditional liquidation market is therefore characterized by fragmented supply and fragmented demand. We utilize the Internet to aggregate both supply and demand and create a more efficient market for liquidation merchandise. We provide consumers and businesses with quick and convenient access to high-quality, brand-name merchandise at discount prices. Our objective is to provide a one-stop destination for discount shopping for products and services proven to be successfully sold through the Internet.

 

Our Business

 

Overstock utilizes the Internet to create a more efficient market for liquidation merchandise. We provide consumers and businesses with quick and convenient access to high-quality, brand-name merchandise at discount prices. As previously mentioned, our shopping business includes both a “direct” business and a “fulfillment partner” business. During the quarter ended March 31, 2006, no single customer accounted for more than 1% of our total revenue. Products from our direct segment and fulfillment partner segment are available to both consumers and businesses through our Wholesale bulk purchase program.

 

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Direct business

 

Our direct business includes sales made to individual consumers and businesses, which are fulfilled from our warehouses in Salt Lake City, Utah or our outsourced warehouses located in Plainfield, Indiana. During the quarter ended March 31, 2006, we fulfilled approximately 38% of all orders through our warehouses. Our warehouses generally ship between 12,000 and 14,000 orders per day, and up to approximately 34,000 orders per day during peak periods, using overlapping daily shifts.

 

Fulfillment partner business

 

For our fulfillment partner business, we sell merchandise of other retailers, cataloguers or manufacturers (“fulfillment partners”) through our Website. We are considered to be the primary obligor for the majority of these sales transactions, and we assume the risk of loss on the returned items. As a consequence, we record revenue from the majority of these sales transactions involving our fulfillment partners (excluding travel products) on a gross basis. Our use of the term “partner” or “fulfillment partner” does not mean that we have formed any legal partnerships with any of our fulfillment partners. We currently have fulfillment partner relationships with approximately 450 third parties which post approximately 62,000 non-BMVG products, as well as most of the BMVG products and a portion of our current travel offerings, on our Websites.

 

Our revenue from sales on our shopping site from both the direct and fulfillment partner businesses is recorded net of returns, coupons and other discounts. Our returns policy for all products other than those sold in our Electronics and Computers department provides for a $4.95 restocking fee and the provision that we will not accept product returns initiated more than twenty days after the shipment date. We charge a 15% restocking fee (instead of the $4.95 restocking fee) on all items returned for non-defective reasons from the Electronics and Computers department.

 

Unless otherwise indicated or required by the context, the discussion herein of our financial statements, accounting policies and related matters, pertains to our shopping sites (Shopping and BMVG) and not necessarily to our auction or travel tabs on our Websites.

 

Bulk buys and business supplies business

 

In August 2004, we merged our B2B site (www.overstockb2b.com) into our B2C site, and opened a “Club O Gold” membership program (into which our current B2B customers were grandfathered). The terms of this program include an annual fee ($99.95), Club O Gold pricing (that is, our B2C price less 5% on single product purchases and steeper discounts for products purchased in bulk), and access to a special, small business-focused, customer service team. During 2005, we morphed this program into our “Bulk Buys & Business Supplies” tab. For this tab, we eliminated the membership fee, and have added a number of suppliers specific to various industry verticals, such as florist supplies, restaurant supplies, and office supplies. The majority of revenue from our bulk buys and business supplies business is included in the fulfillment partner segment, as most of the product sold is supplied by fulfillment partners.

 

Travel business

 

We operate a discount travel department as part of our Website. We use fulfillment partners to supply the travel products and services (flights, hotels, rental cars, etc.). We currently offer air, hotel and car reservation services as well as cruise and vacation packages.

 

On July 1, 2005, we acquired all the outstanding capital stock of Ski West, Inc. (“Ski West”), an on-line travel company whose proprietary technology provides easy consumer access to a large, fragmented, hard-to-find inventory of lodging, vacation, cruise and transportation bargains. The travel products are primarily in popular ski areas in the U.S. and Canada, with more recent expansion into the Caribbean and Mexico, as well as cruises. We paid an aggregate of $25.1 million (including $111,000 of capitalized acquisition related expenses) for Ski West, and we may be subject to additional earn-out payments (based on a percentage of operating profits for each of the four calendar years beginning with 2006 as follows: 50%, 33.3%, 20%, and 10%, respectively), subject to reduction under certain circumstances, pursuant to a Stock Purchase Agreement dated June 24, 2005 and the First Amendment to the Stock Purchase Agreement dated March 1, 2006, among the Company, Ski West, and all of the former shareholders of Ski West.

 

Effective upon the closing, Ski West became our wholly-owned subsidiary, and we integrated the Ski West travel offerings with our existing travel offerings and changed its name to OTravel.com, Inc. OTravel.com generates merchant hotel revenues, which are billed to customers and recognized on a “net” basis at the time of booking since all transactions are nonrefundable and generally noncancelable and OTravel.com has no significant post-delivery obligations. A reserve for chargebacks and cancellations is recorded at the time of the transaction based on historical experience.

 

All other revenues are considered agency revenues and relate primarily to the Company’s existing travel operations. Agency revenues are derived from airline ticket transactions, certain hotel transactions as well as cruise and car rental

 

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reservations. Agency revenues are recognized on a net basis on air transactions when the reservation is made and secured by a credit card. A cancellation allowance is recognized on these revenues based on historical experience. OTravel.com recognizes agency revenues on hotel reservations, cruise and car rental reservations, either on an accrual basis for payments from a commission clearinghouse or on receipt of commissions from an individual supplier. Revenue from our travel business is included in the fulfillment partner segment, as it is not significant enough to separate out as its own segment.

 

Auctions business

 

We operate an online auction service as part of our Website. Our auction tab allows sellers to list items for sale, buyers to bid on items of interest, and users to browse through listed items online. We are not the seller of the items sold on the auction site and we have no control over the pricing of those items. Therefore, for these sales we record only our listing fees and commissions for items sold as revenue. Revenue from our auction business is included in the fulfillment partner segment, as it is not significant enough to segregate as its own segment.

 

Cost of goods sold

 

Cost of goods sold consists of the cost of the product, as well as inbound and outbound freight, fixed warehouse costs, warehouse handling costs, credit card fees, customer service costs and stock-based compensation.

 

Operating expenses

 

Sales and marketing expenses consist primarily of advertising, public relations and promotional expenditures, as well as payroll and related expenses for personnel engaged in marketing and selling activities. Advertising expense is the largest component of our sales and marketing expenses and is primarily attributable to expenditures related to online marketing activities and our offline national radio and television advertising. For the three months ended March 31, 2005 and 2006, our advertising expenses totaled approximately $16.5 million and $12.5 million, respectively, representing 98% and 95%, respectively, of sales and marketing expenses for those respective periods.

 

Technology expenses consist of wages and benefits for technology personnel, rent, utilities, connectivity charges, as well as support and maintenance and depreciation and amortization related to software and computer equipment.

 

General and administrative expenses consist of wages and benefits for executive, legal, accounting, merchandising and administrative personnel, rent and utilities, travel and entertainment, depreciation and amortization of intangible assets and other general corporate expenses.

 

Under SFAS No. 142, any remaining goodwill is not amortized, but is evaluated at least annually for impairment. There were no impairments of goodwill during the quarters ended March 31, 2005 and 2006. In 2005, the Company recorded $10.4 million of goodwill in conjunction with the acquisition of Ski West, Inc.

 

We have recorded no provision or benefit for federal and state income taxes as we have incurred net operating losses since inception. We have provided a full valuation allowance on the net deferred tax assets, consisting primarily of net operating loss carryforwards, because of uncertainty regarding their realizability.

 

Both direct and fulfillment partner revenues are seasonal, with revenues historically being the highest in the fourth quarter, reflecting higher consumer holiday spending. We anticipate this will continue in the foreseeable future.

 

Critical Accounting Policies and Estimates

 

Our consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. Our critical accounting policies are as follows:

 

              revenue recognition;

 

     estimating valuation allowances and accrued liabilities, specifically, the reserve for returns, the allowance for doubtful accounts and the reserve for obsolete and damaged inventory;

 

              internal use software;

 

20



 

     accounting for income taxes;

 

     valuation of long-lived and intangible assets and goodwill; and

 

              stock based compensation and performance share plan.

 

Revenue recognition.   We derive our revenue from four sources: (i) direct revenue, which consists of merchandise sales made to consumers and businesses that are fulfilled from our warehouse; (ii) fulfillment partner revenue, which consists of revenue from the sale of merchandise shipped by fulfillment partners directly to consumers and other businesses, as well as fee revenue collected from the products listed and sold through the auction tab of our Website; and (iii) merchant hotel revenues; and (iv) commission revenue from our auctions and agency travel operations. All sources of revenue are recorded net of returns, coupons redeemed by customers, and other discounts. Revenues from our auction, travel services and bulk buys were not material in the first quarters of 2005 and 2006 and therefore are included in fulfillment partner revenue.

 

We record revenue from the majority of these sales transactions involving our fulfillment partners (excluding auction and travel products) on a gross basis. Similar to our direct revenue segment, fulfillment partner products are available to both consumers and businesses.

 

For sales transactions, we comply with the provisions of Staff Accounting Bulletin 104 “Revenue Recognition”, which states that revenue should be recognized when the following revenue recognition criteria are met: (1) persuasive evidence of an arrangement exists; (2) the product has been shipped or the service provided and the customer takes ownership and assumes the risk of loss; (3) the selling price is fixed or determinable; and (4) collection of the resulting receivable is reasonably assured. We generally require payment by credit card at the point of sale. Amounts received prior to when we ship the goods or provide the services to customers are recorded as deferred revenue. In addition, amounts received in advance for gift cards, and marketing royalties related to our co-branded credit card program are recorded as deferred revenue and recognized in the period earned.

 

Accounting for merchant and agency revenues for our Travel subsidiary.   The determination of gross versus net presentation is based principally on the company’s consideration of Staff Accounting Bulletin No. 101 “Revenue Recognition in Financial Statements” and Emerging Issues Task Force Issue No. 99-19, “Reporting Revenue Gross as a Principal versus Net as an Agent,” including the weighing of the relevant qualitative factors regarding our status as the primary obligor, and the extent of pricing latitude and inventory risk. The method of merchant revenue presentation by the Company does not impact operating profit, net income, or cash flows, but rather revenues and cost of sales.

 

The principal factor in determining gross versus net presentation was the consideration of who is the primary obligor in the relationship with the customer. Our Travel business provides extensive customer service and support for its customers; however, the supplier hotel is principally liable to its merchant hotel customers in all situations where the customer does not receive the hotel services booked through OTravel.com. In this case, OTravel.com provides customer service support to help resolve issues, even though such customer support could typically involve issues for which OTravel.com is not principally liable.

 

OTravel.com generates both merchant hotel revenues and agency air, hotel, car and cruise revenues. Merchant hotel revenues are recognized as net revenue at the time of booking since all transactions are billed directly to customers, are nonrefundable and generally non-cancelable, and require no significant post-delivery obligations for OTravel.com. A reserve for charge-backs and cancellations is recorded at the time of the transaction based on historical experience.

 

Agency revenues are derived from airline ticket transactions, certain hotel transactions as well as cruise and car rental reservations. Agency revenues are recognized on a net basis on air transactions when the reservation is made and secured by a credit card. A cancellation allowance is recognized on these revenues based on historical experience. OTravel.com recognizes agency revenues on hotel reservations, cruise and car rental reservations, either on an accrual basis for payments from a commission clearinghouse or on receipt of commissions from an individual supplier.

 

Reserve for returns, allowance for doubtful accounts and the reserve for obsolete and damaged inventory.   Our management must make estimates of potential future product returns related to current period revenue. Management analyzes historical returns, current economic trends and changes in customer demand and acceptance of our products when evaluating the adequacy of the sales returns reserve and other allowances in any accounting period. The reserve for returns was $5.6 million and $2.2 million as of December 31, 2005 and March 31, 2006, respectively.

 

From time to time, we may grant credit to certain of our business customers on normal credit terms. We perform ongoing credit evaluations of our customers’ financial condition and maintain an allowance for doubtful accounts receivable based upon our historical collection experience and expected collectibility of all accounts receivable. We maintained an allowance for doubtful accounts receivable of $1.2 million and $2.6 million as of December 31, 2005 and March 31, 2006, respectively.

 

21



 

We write down our inventory for estimated obsolescence or damage equal to the difference between the cost of inventory and the estimated market value based upon assumptions about future demand and market conditions. If actual market conditions are less favorable than those projected by management, additional inventory write-downs may be required. Once established, the original cost of the inventory less the related inventory reserve represents the new cost basis of such products. Reversal of these reserves is recognized only when the related inventory has been sold or scrapped. As of March 31, 2006, our inventory balance was $81.4 million, net of allowance for obsolescence or damaged inventory of $3.3 million. At December 31, 2005, our inventory balance was $93.3 million, net of reserve for obsolescence or damaged inventory of $5.2 million.

 

Internal-Use Software and Website Development. Included in fixed assets is the capitalized cost of internal-use software and website development, including software used to upgrade and enhance our websites and processes supporting our business. As required by Statement of Position 98-1, “Accounting for the Costs of Computer Software Developed or Obtained for Internal Use,” we capitalize costs incurred during the application development stage of internal-use software and amortize these costs over the estimated useful life of three years. Costs incurred related to design or maintenance of internal-use software are expensed as incurred.

 

During the first quarters of 2005 and 2006, we capitalized $11.3 million and $8.1 million, respectively, of costs associated with internal-use software and website development, which are partially offset by amortization of previously capitalized amounts of $236,000 and $559,000 for those respective periods.

 

Accounting for income taxes.   Significant management judgment is required in determining our provision for income taxes, our deferred tax assets and liabilities and any valuation allowance recorded against our net deferred tax assets. As of December 31, 2004 and 2005, we have recorded a full valuation allowance of $27.4 million and $36.6 million, respectively, against our net deferred tax asset balance due to uncertainties related to our deferred tax assets as a result of our history of operating losses. The valuation allowance is based on our estimates of taxable income by jurisdiction in which we operate and the period over which our deferred tax assets will be recoverable. In the event that actual results differ from these estimates or we adjust these estimates in future periods, we may need to change the valuation allowance, which could materially impact our financial position and results of operations.

 

Valuation of long-lived and intangible assets and goodwill.   Under SFAS 142, Goodwill and Other Intangible Assets, goodwill is no longer amortized, but must be tested for impairment at least annually. Other long-lived assets must also be evaluated for impairment when management believes that an asset has experienced a decline in value that is other than temporary. Future adverse changes in market conditions or poor operating results of underlying investments could result in losses or an inability to recover the carrying value of the asset that may not be reflected in an asset’s current carrying value, thereby possibly requiring an impairment charge in the future. Goodwill totaled $13.2 million as of December 31, 2005 and March 31, 2006. There was no impairment of goodwill or long-lived assets during the quarters ended March 31, 2005 and 2006.

 

Stock-based compensation.   As of January 1, 2006, we adopted SFAS 123(R), which requires us to measure compensation cost for all outstanding unvested share-based awards at fair value and recognize compensation over the service period for awards expected to vest. The estimation of stock awards that will ultimately vest requires judgment, and to the extent actual results differ from our estimates, such amounts will be recorded as an adjustment in the period estimates are revised. We consider many factors when estimating expected forfeitures, including types of awards, employee class, and historical experience. Actual results may differ substantially from these estimates. We have utilized a Black-Scholes-Merton valuation model to estimate the value of stock options granted to employees. Several of the primary estimates used in measuring stock-based compensation are as follows:

 

Expected Volatility:  The fair value of stock options were valued using a volatility factor based on the Company’s historical stock prices.

 

Expected Term:  The Company’s expected term represents the period that the Company’s stock options are expected to be outstanding and was determined based on historical experience of similar awards, giving consideration to the contractual terms and vesting provisions of the stock-based awards.

 

Expected Dividend:  The Company has not paid any dividends and does not anticipate paying dividends in the foreseeable future.

 

Risk-Free Interest Rate:   The Company bases the risk-free interest rate used on the implied yield currently available on U.S. Treasury zero-coupon issues with remaining term equivalent to the expected term of the options.

 

22



 

Estimated Pre-vesting Forfeitures:  When estimating forfeitures, the Company considers voluntary and involuntary termination behavior.

 

Performance Share Plan. In January 2006 the Board and Compensation Committee  adopted the Overstock.com Performance Share Plan, and approved grants to executive officers and certain employees of the Company. The Performance Share Plan provides for a three-year period for the measurement of the Company’s attainment of the performance goal described in the form of grant, but at the Company’s sole option the Company may make a payment of estimated amounts payable to a plan participant after two years.

 

The performance goal is measured by growth in economic value, as defined in the plan. The amount of payments due to participants under the plan will be a function of the then current market price of a share of the Company’s common stock, multiplied by a percentage dependent on the extent to which the performance goal has been attained, which will be between 0% and 200%. If the growth in economic value is 10% compounded annually or less, the percentage will be 0%. If the growth in economic value is 25% compounded annually, the percentage will be 100%. If the growth in economic value is 40% compounded annually or more, the percentage will be 200%. If the percentage growth is between these percentages, the payment percentage will be determined on the basis of straight line interpolation. Amounts payable under the plan will be payable in cash. During interim and annual.periods prior to the completion of the three-year measurement period, we must record compensation expense based upon the period-end stock price and estimates regarding the ultimate growth in economic value that is expected to occur. These estimates include assumed future growth rates in revenues, gross margins and other factors. If we were to use different assumptions, the estimated compensation charges could be significantly different.

 

As of March 31, 2006, we had accrued approximately $400,000 in compensation expense under the plan.

 

Recent Accounting Pronouncements.

 

In November 2005, the FASB issued FASB Staff Position (“FSP”) Nos. SFAS 115-I and SFAS 124-I, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments. This FSP addresses the three-step determination as to when an investment is considered impaired, whether that impairment is other than temporary, and the measurement of an impairment loss. This FSP also includes accounting considerations subsequent to the recognition of an other-than-temporary impairment and requires certain disclosures about unrealized losses that have not been recognized as other-than-temporary impairments. The guidance in this FSP shall be applied to reporting periods beginning after December 15, 2005. The accounting requirements of FSP 115-1 are effective for us on January 1, 2006 and did not have a material impact on our consolidated financial position, results of operations or cash flows.

 

Results of Operations—2005 compared to 2006

 

Revenue

 

Total revenue grew from $165.9 million during the first quarter of 2005, to $180.2  in 2006, representing growth of 9%. During this same period, direct revenue increased from $67.9 million to $79.7 million (17% growth) and fulfillment partner revenue grew from $98.0 million to $100.5 million (3% growth).

 

The 9% revenue growth we experienced during the first quarter of 2006 was much slower than our historical year over year growth rates have been. This was primarily the result of our focus on improving and fine-tuning system issues that we experienced during the last few months of 2005 that caused growth to begin slowing the last half of the year. Additionally, we believe that this is partially a result of our reducing marketing expenditures by 22% in the first quarter of 2006 ($13.5 million versus $16.5 million during the first quarter of 2005) while we focused our resources on completing prior year initiatives and enhancing the customer experience by improving internal business processes. We anticipate that this strategy will continuethrough the third quarter of 2006, and therefore anticipate similar reduced year over year revenue growth rates during these quarters.

 

Gross Margins

 

Total Gross Margins—Cost of goods sold increased $13.9 million or 10%, from $141.1 million during the quarter ended March 31, 2005 to $155.0 million during the quarter ended March 31, 2006. Total revenue increased 9% (from $165.9 million to $180.2 million) while gross profit increased 2% (from $24.8 million to $25.2 million) during the same periods. As a percent of total revenue, cost of goods sold  increased from 85.1% to 86.0% for those respective periods resulting in gross margins of 14.9% and 14.0% for the quarters ended  March 31, 2005 and 2006, respectively.

 

Generally, our overall gross margins fluctuate based on several factors, including our product mix of sales; sales volumes mix by our direct business and fulfillment partners; changes in vendor pricing; lowering prices for customers, including competitive pricing and inventory management decisions within the direct business; warehouse management costs;

 

23



 

customer service costs; and our discounted shipping offers. Discounted shipping offers reduce shipping revenue, and therefore reduce our gross margins on retail sales.

 

Direct Gross Margins—Gross profits for our direct business decreased 6% from $9.6 million for the quarter ended March 31, 2005 to $9.0 million recorded during the same period in 2006. Gross profits as a percentage of direct revenue were 14.2% and 11.3% for the quarters ended March 31, 2005 and 2006, respectively. The lower gross margins experienced by the direct business are a function of three primary factors. Warehouse costs were higher due to carryover from the systems problems that plagued us in the last part of 2005. To address these issues, we are currently working on an improved build-out of our Salt Lake City warehouse, and we anticipate a decrease in handling costs when this is completed in June. Customer service costs also remained high due to our system problems in 2005, as we emphasized the quality of the customer service experience over cost in the first quarter of 2006. When our new customer service application goes live in June, we expect a significant decrease in these costs. In addition, in our efforts to decrease inventory, we marked down inventory more aggressively than in the past. We expect that inventory markdowns will have a similar effect on margins in the second quarter as we continue to work to decrease overall inventory levels.

 

Fulfillment Partner Gross Margins—Our fulfillment partner business generated gross profits of $15.1 million and $16.2 million for the quarters ended March 31, 2005 and 2006, respectively, an increase of 7%. Gross profits as a percentage of fulfillment partner revenue increased from 15.4% during the first quarter of 2005 to 16.1% during the first quarter of 2006.

 

The increase in gross profits for our fulfillment partner operations was largely due to improvements in product costs, as well as a decrease in BMVG gross bookings as a percentage of fulfillment partner revenue, from 20% in the first quarter of 2005 to 14% in the first quarter of 2006. Gross margins for BMVG products have historically been lower than those of other product categories. The improvements in partner gross profits were partially offset by increased customer services costs incurred in connection with fulfillment partner sales due to issues discussed above.

 

Travel and Auctions Gross Margins - Fulfillment partner gross margins were augmented by the historically higher gross margins from the Travel and Auctions businesses. The gross profits generated by the travel business this year are primarily a result of merchant hotel revenue related to the operations of Ski West, which we acquired on July 1, 2005. Since revenues from sales in both of these businesses are recorded on a net basis, they result in  higher gross margins than our shopping business.

 

Fulfillment

 

Fulfillment costs during the quarters ended March 31, 2005 and 2006 were $11.9 million and $16.9 million, respectively, or 7% and 9% of total revenue for those respective periods. Fulfillment costs include warehousing costs (excluding packaging costs), customer service costs and credit card fees. Fulfillment costs as a percentage of sales may vary due to several factors, such as such as significant changes in the number of units received and fulfilled, the extent we utilize third party fulfillment services and warehouses, and our ability to effectively manage customer service costs and credit card fees.

 

 

 

Three months ended March 31,

 

(in thousands)

 

2005

 

2006

 

Total revenue

 

$

165,881

 

100

%

$

180,206

 

100

%

Cost of goods sold

 

 

 

 

 

 

 

 

 

Product costs and other cost of goods sold

 

129,203

 

78

%

138,065

 

77

%

Fulfillment costs

 

11,916

 

7

%

16,979

 

9

%

Total cost of goods sold

 

141,119

 

85

%

155,044

 

86

%

Gross profit

 

$

24,762

 

15

%

$

25,162

 

14

%

 

This table has been included to provide investors additional information regarding our classification of fulfillment costs and gross margins, thus enabling investors to better compare our fulfillment costs and gross margins with others in our industry. Fulfillment costs include warehouse costs, warehouse handling costs (excluding packaging costs), credit card fees and customer service costs. We believe that some companies in our industry, including some of our competitors, account for fulfillment costs within operating expenses, and therefore exclude fulfillment costs from gross margins. As a result, our gross margins may not be directly comparable to others in our industry.

 

24



 

Operating expenses

 

Sales and marketing.   Sales and marketing expenses totaled $16.8 million and $13.2 million for the quarters ended March 31, 2005 and 2006, respectively, representing a decrease of 22%. For the quarters ended March 31, 2005 and 2006, sales and marketing expenses equaled 10% and 7%, respectively, of total revenue.

 

We direct customers to our Websites primarily through a number of targeted online marketing channels, such as sponsored search, portal advertising, e-mail campaigns, and other initiatives. We also utilize channels such as nation-wide television, print and radio advertising campaigns. Our marketing expense is variable and is measured as a percentage of overall sales.

 

We reduced marketing expenditures in the first quarter of 2006 to focus our resources on completing prior year initiatives and improving internal business processes. Overall revenue increased 9% from the first quarter of 2005 to the first quarter of 2006, while marketing expenditures decreased 22% as we discontinued the least effective marketing efforts in both on-line and television, print and radio campaigns. We intend to continue to spend less on marketing expenditures during the first three quarters of 2006 as we focus on making improvements to existing business processes.

 

While costs associated with our discounted shipping promotions are not included in marketing expense (they are accounted for as a reduction of revenue), we consider discounted shipping promotions as an effective marketing tool, and intend to continue to offer them as we deem appropriate.

 

Sales and marketing expenses also included $70,000 of stock-based compensation related to the adoption of SFAS 123(R) in the first quarter of 2006, compared to $1,000 in the same quarter of 2005.

 

Technology expenses.   Technology expenses increased 232%, from $4.1 million during the quarter ended March 31, 2005 to $13.6 million during same period in 2006.

 

We incurred a “stair-step” increase in technology costs during last nine months of 2005, as we made a significant investment in all of our major systems. As a result,  technology expenses are much higher in the first quarter of 2006 than they were in the first quarter of 2005. The increases in expense are related primarily to increased depreciation expense, as well as increases in maintainance and support costs, and increased IT personnel, including consultants. These increased expenses, combined with slowing growth, will result in a significant increase in technology expenses as a percent of sales for the first nine months of 2006.

 

Although we plan to continue to invest in technology, we expect overall capital expenditures to decrease to approximately $30-$35 million, or half of 2005 levels. This includes some additional investment in our newly expanded infrastructure, including hardware and software used to enhance performance, reliability and stability.

 

Technology expenses also included $159,000 of stock-based compensation related to the adoption of SFAS 123(R) in the first quarter of 2006, compared to $4,000 during the same quarter of 2005.

 

General and administrative expenses.   General and administrative expenses increased 82% from $7.3 million during the quarter ended March 31, 2005 to $13.4 million during the same quarter in 2006, representing 4% and 7% of total revenue for each of the respective periods.

 

The increase in general and administrative expenses in the quarter ended March 31, 2006 compared to the quarter ended March 31, 2005 relates to increases in payroll-related expenses, professional fees, merchandising, legal and finance costs. Also in the third quarter of 2005, we relocated our corporate offices to larger facilities. As a result we now incur additional rent expense of approximately $1.0 million quarterly. Slowing growth, combined with these increases in G&A expense, will result in a significant increase in G&A expense as a percent of sales for the first nine months of 2006.

 

We incurred approximately $633,000 of stock-based compensation within general and administravive expenses for the quarter ended March 31, 2006. We incurred $13,000 in the same quarter of 2005.

 

Overall, a much bigger portion of our technology and general and administrative expenses are now non-cash. We estimate that total depreciation expense will approximate $30 million in 2006. Therefore, including stock-based compensation, these non-cash expenses are estimated to be around $35 million for the year, compared to approximately $16 million of these non-cash expenses in 2005.

 

Performance Share Plan. In January 2006, the Board and Compensation Committee adopted the Overstock.com Performance Share Plan and approved grants to our executive officers and certain employees. The Performance Share Plan provides for a three-year period for the measurement of our attainment of the performance goal described in the form of grant, but at the our sole option we may make a payment of estimated amounts payable to a plan participant after two years.

 

25



 

During the quarter ended March 31, 2006, approximately $400,000 in compensation expense under the plan has been included in general and administrative expenses.

 

Non-operating income (expense)

 

Interest income, interest expense and other income (expense).

 

The primary components of our net interest income, interest expense and other income (expense) are the interest derived from the investment of our excess cash in marketable securities offset by interest expense related to the convertible debt, letters of credit, capital leases, and other related fees.

 

Interest income decreased from $644,000 during the quarter ended March 31, 2005 to $315,000 during the same quarter in 2006 due primarily to a decrease in the amount of cash available to invest. The interest income in the first quarter of 2006 was primarily the result of an increase in the  valuation of our foreign bonds.

 

Under SFAS No. 133, the Foreign Notes were considered to be derivative financial instruments and were marked to market quarterly. Any unrealized gain or loss related to the changes in value of the conditional coupon was recorded in the income statement as a component of interest income or expense. Any unrealized gain or loss related to the changes in the value of the Notes was recorded as a component of other comprehensive income (loss). For the quarter ended March  31, 2006, the combined  fair value of the Foreign Notes increased $758,000. The increase is attributable to changes in the fair value of the conditional coupon resulting in a gain of $273,000, which was recorded in net income, and changes in fair value of the bond instrument resulting in a gain of $485,000, which was recorded as a component of other comprehensive income (loss) in the Balance Sheet. See Note 3—Marketable Securities”. On April 26, 2006, we sold the Foreign Notes for $49.5 million, resulting in a total gain on the bond instrument of $1.9 million, comprised of $1.6 million of unrealized gains and $300,000 of gain which we will recognize in the second quarter of 2006.

 

Interest expense is largely related to our convertible notes, capital leases and our line of credit. Interest expense decreased from $1.4 million during the quarter ended March 31, 2005 to $1.3 million during the same period in 2006.

 

Income taxes

 

Income taxes.   For the quarters ended March 31, 2005 and 2006, we incurred net operating losses, and consequently paid insignificant amounts of federal, state and foreign income taxes. As of December 31, 2005 and March 31, 2006, we had net operating loss carryforwards of approximately $58.0 million and $82.6 million, respectively, which may be used to offset future taxable income. An additional $21.9 million of net operating losses are limited under Internal Revenue Code Section 382 to $799,000 a year. These net operating loss carryforwards will begin to expire in 2019.

 

Supplemental Information about Stock-Based Compensation

 

Periods prior to the adoption of SFAS 123(R)

 

Prior to January 1, 2006, we accounted for stock-based awards under the intrinsic value method, which followed the recognition and measurement principles of APB Opinion No. 25, Accounting for Stock Issued to Employees, and related Interpretations. The intrinsic value method of accounting resulted in compensation expense for for stock options to the extent option exercise prices were set below market prices on the date of grant. Also, to the extent stock awards were forfeited prior to vesting, the corresponding previously recognized expense was reversed as an offset to operating expenses.

 

The following table illustrates the effects on net loss and net loss per share as if we had applied the fair value recognition provisions of SFAS 123(R) to options granted under our stock-based compensation plans prior to the adoption. For purposes of this pro forma disclosure, the value of the options was estimated using the Black-Scholes-Merton (“BSM”) option-pricing formula and amortized on a straight-line basis over the respective vesting periods of the awards. Disclosures for the three months ended March 31, 2006 are not presented because stock-based payments were accounted for under SFAS 123(R)’s fair value method during this period.

 

26



 

 

 

Three months
ended March 31,

 

(in thousands, except per share amounts)

 

2005

 

 

 

 

 

Net loss, as reported

 

$

(4,310

)

 

 

 

 

Add:  Stock-based compensation, as reported

 

20

 

 

 

 

 

Deduct:  Total stock-based compensation expense determined using SFAS 123(R) fair value based method for all awards

 

(904

)

 

 

 

 

Pro forma net loss – SFAS 123 fair value adjusted

 

$

(5,194

)

 

 

 

 

Net loss per common share

 

 

 

Basic and diluted—as reported

 

$

(0.22

)

Basic and diluted—pro forma

 

$

(0.26

)

 

Adoption of SFAS 123(R)

 

As of January 1, 2006, we adopted SFAS No. 123(R) using the modified prospective method, which requires measurement of compensation cost for all stock-based awards at fair value on date of grant and recognition of compensation over the service period for awards expected to vest. The fair value of stock options is determined using the BSM valuation model, which is consistent with our valuation techniques previously utilized for options in footnote disclosures required under SFAS No. 123, Accounting for Stock Based Compensation, as amended by SFAS No. 148, Accounting for Stock-Based Compensation — Transition and Disclosure. Such value is recognized as expense over the service period, net of estimated forfeitures, using the  straight-line method under SFAS 123(R).

 

The adoption of SFAS 123(R) did not result in a cumulative benefit from accounting change, which reflects the net cumulative impact of estimating future forfeitures in the determination of period expense, rather than recording forfeitures when they occur as previously permitted, as we did not have unvested employee stock awards for which compensation expense was recognized prior to adoption of SFAS No. 123(R).

 

On March 29, 2005, the SEC published Staff Accounting Bulletin (“SAB”) No. 107, which provides the Staff’s views on a variety of matters relating to stock-based payments. SAB 107 requires stock-based compensation be classified in the same expense line items as cash compensation. We have reclassified stock-based compensation from prior periods to correspond to current period presentation within the same operating expense line items as cash compensation paid to employees.

 

The application of SFAS 123(R) had the following effect on the first quarter of March 31, 2006 reported amounts relative to amounts that would have been reported using the intrinsic value method under previous accounting (in thousands, except per share amounts):

 

 

 

SFAS 123(R)
Adjustments

 

 

 

 

 

Operating loss

 

$

(958

)

Net loss

 

$

(958

)

 

 

 

 

Net loss per common share – basic and diluted

 

$

(0.05

)

 

Seasonality

 

Based upon our historical experience, increased revenues typically occur during the fourth quarter because of the Christmas retail season. The actual quarterly results for each quarter could differ materially depending upon consumer preferences, availability of product and competition, among other risks and uncertainties. Accordingly, there can be no assurances that seasonal variations will not materially affect our results of operations in the future. The following table reflects our revenues for each of the quarters available since 2000 (in thousands):

 

 

 

First
Quarter

 

Second
Quarter

 

Third
Quarter

 

Fourth
Quarter

 

2006

 

$

180,206

 

 

 

 

 

 

 

2005

 

165,881

 

$

150,638

 

$

169,323

 

$

317,980

 

2004

 

82,078

 

87,792

 

103,444

 

221,321

 

2003

 

29,164

 

28,833

 

57,788

*

123,160

 

2002

 

12,067

 

14,380

 

23,808

 

41,529

 

2001

 

9,578

 

7,407

 

8,744

 

14,274

 

2000

 

2,257

 

3,795

 

4,339

 

15,132

 

 

27



 


*       Note that total revenue since the third quarter of 2003 reflects the change in our policy in which sales by fulfillment partners are recorded “gross” instead of “net” as in prior quarters.

 

Liquidity and Capital Resources

 

At March 31, 2006, our cash and cash equivalents balance was $2.6 million and our marketable securities totaled $49.2 million. Subsequent to the end of the first quarter, we sold the marketable securities for $49.5 million in cash, and raised approximately $25.0 million by selling common stock to one investor. On May 8, 2006 we agreed to sell an additional 700,000 shares of common stock to another investor for an aggregate price of $16.8 million; however, on May 9, 2006 we offered to terminate this purchase agreement, and on May 10, 2006 the investor elected to do so.

 

Our operating activities resulted in net cash outflows of $35.2 million and $72.8 million for the quarters ended March 31, 2005 and 2006, respectively. The primary use of cash and cash equivalents during the first quarter of 2006 was to fund our operations, including net losses of $15.9 million, as well as a  reduction in accounts payable and accrued liabilities by $64.3 million and $15.7 million, respectively. This was offset by the cash provided from a reduction in inventory of $11.9 million and collections of accounts receivable of $3.4 million. We plan to enhance operating cash flows by reducing inventory an additional $15 to $20 million over the next few months.

 

We have payment terms with our fulfillment partners that extend beyond the amount of time necessary to collect proceeds from our customers. As a result, following our seasonally strong fourth quarter sales, at December 31 of each year, our cash, cash equivalents, marketable securities and accounts payable balances typically reach their highest level (other than as a result of cash flows provided by or used in investing and financing activities). However, our accounts payable balance normally decline during the first three months following year-end, which normally results in a decline in our cash, cash equivalents, and marketable securities balances in the first quarter each year.

 

Due to the seasonality in our sales and operating cash flows on a quarterly basis, we believe the trailing twelve month (“TTM”) operating cash flow to be a better indication of our true operating cash flow. For the twelve months ending March 31, 2006, the TTM operating cash flows were $(43.7) million versus $11.7 million for the TTM ending March 31, 2005. Of this amount, $31.0 million relates to increased inventory balances in 2006 over 2005, with the balance primarily a result of cash losses over the past twelve months.

 

Net cashflows used in investing activities totaled $79.1 million and $534,000 for the quarters ended March 31, 2005 and 2006, respectively. In the first quarter of 2006, the primary outflows during this period included $6.8 million in capital expenditures for property and equipment offset by a net increase of $7.3 million from the sale of marketable securities.

 

Cash outflows for financing activities for the quarter ended March 31, 2005 totaled $46.8 million, consisting primarily of cash used in the purchase of call options to buy back shares of our common stock. Net cash provided by financing activities during the quarter ended March 31, 2006 totaled $18.6 million, consisting primarily of cash used for payments of capital leases of $2.4 million and payoff of the line of credit of $10.7 offset by proceeds from the borrowings on the line of credit of $30.7 and exercise of stock options  of $1.0 million.

 

While we believe that the cash and marketable securities currently on hand, amounts available under our credit facility and expected cash flows from future operations will be sufficient to continue operations for at least the next twelve months, we may require additional financing. However, there can be no assurance that if additional financing is necessary it will be available, or, if available, that such financing can be obtained on satisfactory terms. Failure to generate sufficient revenues, generate profitability or raise additional capital could have a material adverse effect on our ability to continue as a going concern and to achieve our intended business objectives. Any projections of future cash needs and cash flows are subject to substantial uncertainty.

 

Contractual Obligations and Commitments.   The following table summarizes our contractual obligations as of March 31, 2006 and the effect such obligations and commitments are expected to have on our liquidity and cash flow in future periods:

 

 

 

Payments Due by Period
(in thousands)

 

Contractual Obligations

 

Total

 

Less than
1 Year

 

1-3 Years

 

4-5 Years

 

After
5 years

 

Long-term debt arrangements

 

$

75,021

 

$

 

$

 

$

 

$

75,021

 

Interest on convertible senior notes

 

17,566

 

3,850

 

5,775

 

5,775

 

2,166

 

Capital lease obligations

 

9,623

 

5,654

 

3,967

 

2

 

 

Operating leases

 

71,954

 

7,639

 

14,246

 

16,452

 

33,617

 

Purchase obligations

 

31,940

 

31,940

 

 

 

 

Line of Credit

 

20,000

 

20,000

 

 

 

 

 

 

 

Total contractual cash obligations

 

$

226,104

 

$

69,083

 

$

23,988

 

$

22,229

 

$

110,804

 

 

 

 

 

 

 

 

 

 

 

 

 

 

28



 

 

 

Amounts of Commitment Expiration Per Period
(in thousands)

 

Other Commercial Commitments

 

Total
Amounts
Committed

 

Less than
Year 1

 

1-3 Years

 

4-5 Years

 

Over
5 years

 

Letters of credit

 

$

13,134

 

$

13,134

 

$

 

$

 

$

 

Redeemable common stock

 

2,684

 

2,684

 

 

 

 

Total commercial commitments

 

$

15,818

 

$

15,818

 

$

 

$

 

$

 

 

3.75% Convertible Senior Notes

 

In November 2004, we completed an offering of $120.0 million of 3.75% Convertible Senior Notes (the “Senior Notes”). Interest on the Senior Notes is payable semi-annually on June 1 and December 1 of each year. The Senior Notes mature on December 1, 2011 and are unsecured and rank equally in right of payment with all existing and future unsecured, unsubordinated debt and senior in right of payment to any existing and future subordinated indebtedness. The Senior Notes are convertible at any time prior to maturity into our common stock at the option of the note holders at a conversion price of $76.23 per share (subject to adjustment in certain events, including stock splits, dividends and other distributions and certain repurchases of our stock, as well as certain fundamental changes in the ownership of the Company).

 

Beginning December 1, 2009, we have the right to redeem the Senior Notes, in whole or in part, for cash at 100% of the principal amount plus accrued and unpaid interest. Upon the occurrence of a fundamental change (including the acquisition of a majority interest in the Company, certain changes in the Company’s board of directors or the termination of trading of our stock) meeting certain conditions, holders of the Senior Notes may require us to repurchase for cash all or part of their notes at 100% of the principal amount plus accrued and unpaid interest.

 

In 2005, under the Share Repurchase Program discussed below, we retired $43.0 million of the Senior Notes  for $35.7 million in cash. As a result of the note retirements, we recognized a gain of $6.2 million, net of the associated unamortized discount of $1.2 million for the year ended December 31, 2005. As of March 31, 2006, $77.0 million of Senior Notes remain outstanding.

 

Lease and Purchase Obligations

 

The lease obligations include our obligations under a ten-year lease agreement we entered in December 2004 for approximately 154,000 square feet of office space in Salt Lake City. We took possession of the new office space in July of 2005, and terminated our lease obligations under our previous office lease agreements at the same time. The total lease obligation over the ten-year term of the new lease is $39.6 million, of which approximately $3.5 million will be payable in 2006. In connection with the preparation of the new office space, we have provided a letter of credit for $500,000 to provide funds for the removal of the improvements upon termination of the new sublease and have also agreed to pay approximately $2.0 million for leasehold improvements. We paid for the majority of the leasehold improvements during 2005.

 

The amount of purchase obligations shown is based on assumptions regarding the legal enforceability against us of purchase orders we had outstanding at March 31, 2006. Under different assumptions regarding our rights to cancel our purchase orders or different assumptions regarding the enforceability of the purchase orders under applicable law, the amount of purchase obligations shown in the table above would be less.

 

Borrowings

 

$30.0 million Amended Credit Agreement

 

On October 18, 2005, the Company entered into a sixth amendment to a credit agreement (“Amended Credit Agreement”) with Wells Fargo Bank, National Association. The Amended Credit Agreement provides a revolving line of credit to the Company of up to $30.0 million which we use primarily to obtain letters of credit to support inventory purchases. Borrowings under the line of credit are collateralized by our foreign bond securities, which have an aggregate principal amount of $50.0 million. The Amended Credit Agreement expires on December 31, 2007, however, we have an option to renew the Amended Credit Agreement annually. Interest on borrowings is payable monthly and accrued at either (i) 1.35% above LIBOR in effect on the first day of an applicable fixed rate term, or (ii) at a fluctuating rate per annum determined by the bank to be one half a percent (0.50%) above daily LIBOR in effect on each business day a change in daily LIBOR is announced by the bank. Unpaid principal, together with accrued and unpaid interest is due on the maturity date.

 

29



 

The Amended Credit Agreement requires us to comply with certain covenants, including restrictions on mergers, business combinations or transfer of assets. We were in compliance with these covenants at  March 31, 2006.

 

At March 31, 2006, borrowings under the Amended Credit Agreement were collateralized by our Foreign Notes, which had an aggregate principal amount of $50.0 million. On April 26, 2006, we sold the Foreign Notes and borrowings under the Amended Credit Agreement are now collateralized by cash balances held at Wells Fargo Bank, National Association.

 

At March 31, 2006, no amounts were outstanding under the Amended Credit Agreement, and Letters of Credit totaling $13.1 million were issued on our behalf.

 

$40.0 million WFRF Agreement

 

On December 12, 2005, we entered into a Loan and Security Agreement (the “WFRF Agreement”) with Wells Fargo Retail Finance, LLC and related security agreements and other agreements described in the WFRF Agreement.

 

The WFRF Agreement provides for advances to us and for the issuance of letters of credit for its account of up to an aggregate maximum of $40.0 million. We have the right to increase the aggregate maximum amount available under the facility to up to $50.0 million during the first two years of the facility. The amount actually available to us may be less and may vary from time to time, depending on, among other factors, the amount of its eligible inventory and receivables. Our obligations under the WFRF Agreement and all related agreements are collateralized by all or substantially all of our and our subsidiaries’ assets. Our obligations under the WFRF Agreement are cross-collateralized with our assets pledged under its $30.0 million credit facility with Wells Fargo Bank, National Association. The term of the WFRF Agreement is three years, expiring on December 12, 2008. The WFRF Agreement contains standard default provisions.

 

Advances under the WFRF Agreement bear interest at either (a) the rate announced, from time to time, within Wells Fargo Bank, National Association at its principal office in San Francisco as its “prime rate” or (b) a rate based on LIBOR plus a varying percentage between 1.25% and 1.75%; however, the annual interest rate on advances under the WFRF Agreement will be at least 3.50%. The WFRF Agreement includes affirmative covenants as well as negative covenants that prohibit a variety of actions without the lender’s approval, including covenants that limit our ability to (a) incur or guarantee debt, (b) create liens, (c) enter into any merger, recapitalization or similar transaction or purchase all or substantially all of the assets or stock of another person, (d) sell assets, (e) change our name or the name of any of our subsidiaries, (f) make certain changes to our business, (g) optionally prepay, acquire or refinance indebtedness, (h) consign inventory, (i) pay dividends on, or purchase, acquire or redeem shares of, our capital stock, (j) change our method of accounting, (k) make investments, (l) enter into transactions with affiliates, or (m) store any of our inventory or equipment with third parties. We were in compliance with these covenants as of March 31, 2006.

 

At March 31, 2006, we had $20.0 million of borrowings on the WFRF Agreement.

 

Redeemable Common Stock

 

The estimated amount of redeemable common stock is based solely on the statutes of limitations of the various states in which stockholders may have rescission rights and may not reflect the actual results. The stock is not redeemable by its terms. We do not have any unconditional purchase obligations, other long-term obligations, guarantees, standby repurchase obligations or other commercial commitments. These recscission rights, if any, expire December 31, 2006.

 

Share Repurchase Program

 

During January 2005, our Board of Directors authorized a share repurchase program under which we were authorized to repurchase up to $50.0 million of our common stock through December 31, 2007. On April 26, 2005, the Board of Directors increased the amount of the share repurchase program to $100.0 million. Additionally, on June 14, 2005, the Board of Directors authorized an amendment of our three-year share repurchase program to include the repurchase of our Convertible Senior Notes.

 

Under the repurchase program, we repurchased approximately 665,000 shares of our common stock in open market transactions for $24.1 million during the year ended December 31, 2005. In addition, approximately 1.0 million shares of common stock were acquired as a result of the settlement of $41.1 million of structured stock repurchase transactions during the year ended December 31, 2005. The purchased call options that did not settle in stock settled in cash totaling $7.9 million, which we received in July 2005. We also repurchased convertible senior notes having an aggregate principal amount of $43.0 million. As of March 31, 2006, we have utilized all of the $100.0 million authorized by the board of directors under the share repurchase program.

 

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Shelf Registration

 

In April 2005, we filed a registration statement with the Securities and Exchange Commission using a “shelf” registration or continuous offering process. Under this shelf process, we may, from time to time, sell any or all of the securities described in the prospectus in one or more offerings up to a total dollar amount of $500.0 million.

 

On May 1, 2006, we issued approximately $1.0 million shares of common stock for an aggregate price of $25.0 million. On May 8, 2006, we agreed to issue an additional 700,000 shares of common stock for an aggregate price of $16.8 million; however, on May 9, 2006 we offered to terminate this agreement, and on May 10, 2006 the purchaser elected to do so..

 

While we believe that the cash and marketable securities currently on hand, amounts available under our credit facility and expected cash flows from future operations will be sufficient to continue operations for at least the next twelve months, we may require additional financing. However, there can be no assurance that if additional financing is necessary it will be available, or, if available, that such financing can be obtained on satisfactory terms. Failure to generate sufficient revenues, generate profitability or raise additional capital could have a material adverse effect on our ability to continue as a going concern and to achieve our intended business objectives. Any projections of future cash needs and cash flows are subject to substantial uncertainty.

 

Government Regulation

 

All of our services are subject to federal and state consumer protection laws including laws protecting the privacy of consumer non-public information and regulations prohibiting unfair and deceptive trade practices. In particular, under federal and state financial privacy laws and regulations, we must provide notice to consumers of our policies on sharing non-public information with third parties, must provide advance notice of any changes to our policies and, with limited exceptions, must give consumers the right to prevent sharing of their non-public personal information with unaffiliated third parties. Furthermore, the growth and demand for online commerce could result in more stringent consumer protection laws that impose additional compliance burdens on online companies. These consumer protection laws could result in substantial compliance costs and could interfere with the conduct of our business.

 

In many states, there is currently great uncertainty whether or how existing laws governing issues such as property ownership, sales and other taxes, libel and personal privacy apply to the Internet and commercial online services. These issues may take years to resolve. In addition, new state tax regulations may subject us to additional state sales and income taxes. New legislation or regulation, the application of laws and regulations from jurisdictions whose laws do not currently apply to our business or the application of existing laws and regulations to the Internet and commercial online services could result in significant additional taxes on our business. These taxes could have an adverse effect on our cash flows and results of operations. Furthermore, there is a possibility that we may be subject to significant fines or other payments for any past failures to comply with these requirements.

 

Factors that May Affect Future Results

 

Any investment in our securities involves a high degree of risk. Investors should consider carefully the risks and uncertainties described below, and all other information in this Form 10-Q and in our other filings with the SEC including those we file after we file this Form 10-Q, before deciding whether to purchase or hold our securities. Additional risks and uncertainties not currently known to us or that we currently deem immaterial may also become important factors that may harm our business. The occurrence of any of the following risks could harm our business. The trading price of our securities could decline due to any of these risks and uncertainties, and investors may lose part or all of their investment.

 

ITEM 3.          QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

 

Our financial instruments consist of cash and cash equivalents, marketable securities, trade accounts and contracts receivable, accounts payable and long-term obligations. We consider investments in highly-liquid instruments purchased with a remaining maturity of 90 days or less at the date of purchase to be cash equivalents. Our exposure to market risk for changes in interest rates relates primarily to our short-term investments and short-term obligations; thus, fluctuations in interest rates would not have a material impact on the fair value of these securities.

 

At March 31, 2006, we had $2.6 million in cash and cash equivalents and $49.2 million in marketable securities. A hypothetical increase or decrease in interest rates of one hundred basis points would have an estimated impact of approximately $130,000 on our loss for the quarter ended March 31, 2006, or the fair market value or cash flows of these instruments.

 

At March 31, 2006, we had approximately $77.0 million of convertible senior notes outstanding which bear interest at a fixed rate of 3.75%. In addition, at March 31, 2006, we had $20.0 million in borrowings outstanding under our lines of credit and letters of credit totaling $13.1 million were outstanding under our credit facilities.

 

The fair value of the convertible senior notes is sensitive to interest rate changes. Interest rate changes would result in increases or decreases in the fair value of the convertible senior notes, due to differences between market interest rates and

 

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rates in effect at the inception of the obligation. Unless we elect to repurchase our convertible senior notes in the open market, changes in the fair value of convertible senior notes have no impact on our cash flows or consolidated financial statements. The estimated fair value of our 3.75% Convertible Senior Notes as of March 31, 2006 and December 31, 2005 was $58.5 million and $54.7 million, respectively.

 

ITEM 4.          CONTROLS AND PROCEDURES

 

Disclosure Controls and Procedures

 

The Company maintains disclosure controls and procedures that are designed to ensure that information relating to the Company and its consolidated subsidiaries required to be disclosed in the Company’s periodic filings under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), is recorded, processed, summarized and reported in a timely manner in accordance with the requirements of the Exchange Act, and that such information is accumulated and communicated to management, including the Company’s Chief Executive Officer (principal executive officer) and Senior Vice President, Finance (principal financial officer), as appropriate, to allow timely decisions regarding required disclosure. The Company carried out an evaluation, under the supervision and with the participation of management, including the Chief Executive Officer (principal executive officer) and Senior Vice President, Finance (principal financial officer), of the effectiveness of the design and operation of these disclosure controls and procedures, as such term is defined in Exchange Act Rule 13a-15(e), as of March 31, 2006. Based on this evaluation, the Chief Executive Officer (principal executive officer) and Senior Vice President, Finance (principal financial officer) each concluded that the Company’s disclosure controls and procedures were effective as of March 31, 2006.

 

Changes in Internal Control Over Financial Reporting

 

During the quarter ended March 31, 2006, the Company implemented controls designed to remediate the material weakness over the accounting for inventory that arose from the Company’s former practice of immediately expensing inbound freight costs in the period incurred rather that capitalizing such costs as a component of inventory and expensing such costs as the related inventory is sold, which was reported in the Company’s annual consolidated financial statements included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2005. More specifically the Company implemented the following procedures:

 

      Management prepares an analysis on a monthly basis to ensure that the proper amount of inbound freight costs are capitalized as a component of inventory and expensed as the related inventory is sold in accordance AICPA Accounting Research Bulletin No. 43, Restatement and Revision of Accounting Research Bulletins, Chapter 4, “Inventory Pricing”.

 

      The monthly inbound freight analysis is reviewed and approved by the appropriate level of management.

 

      To ensure that the inbound freight analysis is performed each month, this procedure has been added to the Company’s monthly closing checklist (which is reviewed each month for completeness by management).

 

We have evaluated the design of these new procedures and controls, placed them in operation for a sufficient period of time, and subjected them to appropriate tests, in order to conclude that they are operating effectively. We have therefore concluded that the above referenced material weakness has been fully remediated as of March 31, 2006.

 

There have been no other changes in the Company’s internal control over financial reporting that occurred during the quarter ended March 31, 2006 that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

 

PART II. OTHER INFORMATION

 

ITEM 1.          LEGAL PROCEEDINGS

 

From time to time, we receive claims of and become subject to consumer protection, employment, intellectual property and other commercial litigation related to the conduct of our business. Such litigation could be costly and time consuming and could divert our management and key personnel from our business operations. The uncertainty of litigation increases these risks. In connection with such litigation, we may be subject to significant damages or equitable remedies relating to the operation of our business and the sale of products on our websites. Any such litigation may materially harm our business,

 

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prospects, results of operations, financial condition and cash flows. However, we do not currently believe that any of our outstanding litigation will have a material impact on our financial statements.

 

In October 2003, Tiffany (NJ) Inc. and Tiffany and Company filed a complaint against us in the United States District Court for the Southern District of New York alleging that we have distributed counterfeit and otherwise unauthorized Tiffany product in violation of federal copyright and trademark law and related state laws. The complaint seeks statutory and other damages in an unspecified amount and injunctive relief. In January and February 2005, Tiffany (NJ) Inc. and Tiffany and Company filed five additional complaints against us in the United States District Court for the Southern District of New York alleging that we have distributed counterfeit and otherwise unauthorized Tiffany product in violation of federal copyright and trademark law and related state laws. We have recently reached an agreement in principle that will settle and dismiss all of the cases. We are currently working on a definitive settlement agreement with Tiffany.

 

In September 2004, we received a letter from BTG International Inc. claiming that certain of our business practices and online marketing information technology systems infringe patents owned by BTG. On September 14, 2004, without engaging in any meaningful discussion or negotiation with us, BTG filed a complaint in the United States District Court of Delaware alleging that certain of our business practices and online marketing information technology systems infringe a single patent owned by BTG. On October 21, 2004, we filed an answer denying the material allegations in BTG’s claims. We have recently reached an agreement in principle that will settle and dismiss the case. We are currently working on a definitive settlement agreement with BTG.

 

In December 2003, we received a letter from Furnace Brook claiming that certain of our business practices and our on-line ordering system infringe a single patent owned by Furnace Brook. After diligent efforts to show that we do not infringe the patent and Furnace Brook’s continual demands that we enter into licensing arrangements with respect to the asserted patent, on August 12, 2005, we filed a complaint in the United States District Court of Utah, Central Division, seeking declaratory judgment that we do not infringe any valid claim of the Furnace Brook patent. Furnace Brook filed a motion to dismiss our complaint for lack of personal jurisdiction over Furnace Brook in Utah. On October 31, 2005, the United States District Court of Utah, Central Division, issued a decision to dismiss our complaint for lack of personal jurisdiction over Furnace Brook. On December 14, 2005, we filed an appeal of the Utah decision with the United States Court of Appeals for the Federal Circuit. On August 18, 2005, shortly after we filed the complaint in Utah, Furnace Brook filed a complaint in the United States District Court for the Southern District of New York, alleging that certain of our business practices and our on-line ordering system infringe a single patent owned by Furnace Brook. On September 9, 2005 we filed an answer denying the material allegations in Furnance Brook’s claims. Although we have filed an answer and believe we have defenses to the allegations and intend to pursue them vigorously, the Furnace Brook lawsuit is in the discovery stage, and we do not have sufficient information to assess the probability of success or the amount of potential damages.

 

On August 11, 2005, along with a shareholder plaintiff, we filed a complaint against Gradient Analytics, Inc.; Rocker Partners, LP; Rocker Management, LLC; Rocker Offshore Management Company, Inc. and their respective principals. We, along with a second shareholder plaintiff, filed the complaint in the Superior Court of California, County of Marin. On October 12, 2005, we filed an amended complaint against the same entities alleging libel, intentional interference with prospective economic advantage and violations of California’s unfair business practices act. On March 7, 2006, the court denied the defendants demurrers to and motions to strike the amended complaint. The defendants have each filed a motion to appeal the court’s decision; the court has ruled that this appeal stays discovery in the case. We intend to pursue this action vigorously.

 

On May 9, 2006 we received a notice of an investigation and subpoena from the Securities and Exchange Commission, Salt Lake City District Office.  The subpoena requests a broad range of documents, including, among other documents, all documents relating to our accounting policies, our targets, projections or estimates related to financial performance, our recent restatement of its financial statements, the filing of our complaint against Gradient Analytics, Inc., the development and implementation of certain new technology systems and disclosures of progress and problems with those systems, communications with and regarding investment analysts, communications regarding shareholders who did not receive our proxy statement in April 2006, communications with certain shareholders, and communications regarding short selling, naked short selling, purchases and sales of our stock, obtaining paper certificates, and stock loan or borrow of our shares. We intend to review the subpoena and respond in due course.

 

ITEM 1A.       RISK FACTORS

 

These forward-looking statements are subject to risks and uncertainties that could cause actual results and events to differ materially. For a detailed discussion of these risks and uncertainties please see Item 1A – Risk Factors and the description of risk factors set forth in our Annual Report on Form 10-K for the year ended December 31, 2005. These forward-looking statements speak only as of the date of this report and, except as required by law, we undertake no obligation to update forward-looking statements to reflect events or circumstances occurring after the date of this report.

 

Risks Relating to Overstock

 

We have a history of significant losses. If we do not achieve profitability, our financial condition and our stock price could suffer.

 

We have a history of losses and we may continue to incur operating and net losses for the foreseeable future. We incurred net losses attributable to common shares of $4.4 million and $15.9 million for the quarters ended March 31, 2005 and 2006, respectively. As of December 31, 2005 and March 31, 2006, our accumulated deficit was $96.8 million and $112.8 million, respectively. We will need to generate significant revenues to achieve profitability, and we may not be able to do so. Even if

 

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we do achieve profitability, we may not be able to sustain or increase profitability on a quarterly or annual basis in the future. If our revenues grow more slowly than we anticipate, or if our operating expenses exceed our expectations, our financial results would be harmed.

 

We will continue to incur significant operating expenses and capital expenditures as we:

 

      enhance our distribution and order fulfillment capabilities;

 

      further improve our order processing systems and capabilities;

 

      develop enhanced technologies and features;

 

      expand our customer service capabilities to better serve our customers’ needs;

 

      expand our product offerings, including our auctions site, our travel site and our custom design jewelry site;

 

      rent additional warehouse and office space;

 

      increase our general and administrative functions to support our operations; and

 

      maintain or increase our sales, branding and marketing activities, including maintaining existing or entering into new online marketing arrangements, and continuing or increasing our national television and radio branding campaigns.

 

Because we will incur many of these expenses before we receive any revenues from our efforts, our losses may be greater than the losses we would incur if we developed our business more slowly. Further, we base our expenses in large part on our operating plans and future revenue projections. Many of our expenses are fixed in the short term, and we may not be able to quickly reduce spending if our revenues are lower than we project. Therefore, any significant shortfall in revenues would likely harm our business, prospects, operating results and financial condition. In addition, we may find that these efforts are more expensive than we currently anticipate which would further increase our losses. Also, the timing of these expenses may contribute to fluctuations in our quarterly operating results.

 

If we fail to accurately forecast our expenses and revenues, our business, operating results and financial condition may suffer and the price of our securities may decline.

 

Our limited operating history and the rapidly evolving nature of our industry make forecasting operating results difficult. We have recently completed several large, complex and expensive infrastructure upgrades in order to increase our ability to handle larger volumes of sales and to develop or increase our ability to perform a variety of analytical procedures relating to our business, and we are continuing the work to upgrade and further expand these and other components of our infrastructure. We have experienced difficulties with the implementation of various aspects to the upgrades of our infrastructure, and have incurred increased expenses as a result of these difficulties. As a result of these expenditures, our ability to quickly reduce spending if our revenues are lower than we project is limited. Therefore, any significant shortfall in the revenues for which we have built and are continuing to build our infrastructure would likely harm our business, prospects, operating results and financial condition and cause our results of operation to fall below the expectations of public market analysts and investors. If this occurs, the price of our securities may decline.

 

We depend on our relationships with third party fulfillment partners for a large portion of the products that we offer for sale on our Websites. If we fail to maintain these relationships, our business will suffer.

 

At March 31, 2006, we had fulfillment partner relationships with approximately 450 third parties whose products we offer for sale on our Websites. These products accounted for approximately 80% of the non-BMVG products available. We do not have any long-term agreements with any of these third parties. Our agreements with third parties are terminable at will by either party immediately upon notice. In general, we agree to offer the third parties’ products on our Websites and these third parties agree to provide us with information about their products, honor our customer service policies and ship the products directly to the customer. If we do not maintain our existing or build new relationships with third parties on acceptable commercial terms, we may not be able to offer a broad selection of merchandise, and customers may refuse to shop at our Websites. In addition, manufacturers may decide not to offer particular products for sale on the Internet. If we are unable to maintain our existing or build new fulfillment partner relationships or if other product manufacturers refuse to allow their products to be sold via the Internet, our business and prospects would suffer severely.

 

We are partially dependent on third parties to fulfill a number of our fulfillment, distribution and other retail functions. If such parties are unwilling or unable to continue providing these services, our business could be seriously harmed.

 

In our fulfillment partner business, although we handle returned merchandise, we continue to rely on third parties to conduct a number of other traditional retail operations with respect to their respective products that we offer for sale on our

 

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Websites, including maintaining inventory, preparing merchandise for shipment to individual customers and timely distribution of purchased merchandise. We have no effective means to ensure that these third parties will continue to perform these services to our satisfaction or on commercially reasonable terms. In addition, because we do not take possession of these third parties’ products, we are unable to fulfill these traditional retail operations ourselves. Our customers could become dissatisfied and cancel their orders or decline to make future purchases if these third parties are unable to deliver products on a timely basis. If our customers become dissatisfied with the services provided by these third parties, our reputation and the Overstock.com brand could suffer.

 

We rely on our relationships with manufacturers, retailers and other suppliers to obtain sufficient quantities of quality merchandise on acceptable terms. If we fail to maintain our supplier relationships on acceptable terms, our sales and profitability could suffer.

 

To date, we have not entered into contracts with manufacturers or liquidation wholesalers that guarantee the availability of merchandise for a set duration. Our contracts or arrangements with suppliers do not provide for the continuation of particular pricing practices and may be terminated by either party at any time. Our current suppliers may not continue to sell their excess inventory to us on current terms or at all, and we may not be able to establish new supply relationships. For example, it is difficult for us to maintain high levels of product quality and selection because none of the manufacturers, suppliers and liquidation wholesalers from whom we purchase products on a purchase order by purchase order basis have a continuing obligation to provide us with merchandise at historical levels or at all. In most cases, our relationships with our suppliers do not restrict the suppliers from selling their respective excess inventory to other traditional or online merchandise liquidators, which could in turn limit the selection of products available on our Websites. If we are unable to develop and maintain relationships with suppliers that will allow us to obtain sufficient quantities of merchandise on acceptable commercial terms, such inability could harm our business, prospects, results of operation and financial condition.

 

We depend upon third-party delivery services to deliver our products to our customers on a timely and consistent basis. Deterioration in our relationship with any one of these third parties could decrease our ability to track shipments, cause shipment delays, and increase our shipping costs and the number of damaged products.

 

We rely upon multiple third parties for the shipment of our products. Because we do not have a written long-term agreement with any of these third parties, we cannot be sure that these relationships will continue on terms favorable to us, if at all. Unexpected increases in shipping costs or delivery times, particularly during the holiday season, could harm our business, prospects, financial condition and results of operations. If our relationships with these third parties are terminated or impaired or if these third parties are unable to deliver products for us, whether through labor shortage, slow down or stoppage, deteriorating financial or business condition, responses to terrorist attacks or for any other reason, we would be required to use alternative carriers for the shipment of products to our customers. In addition, conditions such as adverse weather can prevent any carriers from performing their delivery services, which can have an adverse effect on our customers’ satisfaction with us. In any of these circumstances, we may be unable to engage alternative carriers on a timely basis, upon terms favorable to us, or at all. Changing carriers would likely have a negative effect on our business, prospects, operating results and financial condition. Potential adverse consequences include:

 

      reduced visibility of order status and package tracking;

 

      delays in order processing and product delivery;

 

      increased cost of delivery, resulting in reduced gross margins; and

 

      reduced shipment quality, which may result in damaged products and customer dissatisfaction.

 

A significant number of merchandise returns could harm our business, financial condition and results of operations.

 

We allow our customers to return products and, beginning July 1, 2003, we started accepting returns of products sold through our fulfillment partners. We modify our policies relating to returns from time to time, and any policies intended to reduce the number of product returns may result in customer dissatisfaction and fewer return customers. If merchandise returns are significant, our business, prospects, financial condition and results of operations could be harmed.

 

If the products that we offer on our Websites do not reflect our customers’ tastes and preferences, our sales and profit margins would decrease.

 

Our success depends in part on our ability to offer products that reflect consumers’ tastes and preferences. Consumers’ tastes are subject to frequent, significant and sometimes unpredictable changes. Because the products that we sell typically consist of manufacturers’ and retailers’ excess inventory, we have limited control over the specific products that we are able to offer for sale. If our merchandise fails to satisfy customers’ tastes or respond to changes in customer preferences, our sales could suffer and we could be required to mark down unsold inventory which would depress our profit margins. In addition,

 

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any failure to offer products in line with customers’ preferences could allow our competitors to gain market share. This could have an adverse effect on our business, prospects, results of operations and financial condition.

 

We face risks relating to our inventory.

 

We directly purchase some of the merchandise that we sell on our Websites. We assume the inventory damage, theft and obsolescence risks, as well as price erosion risks for products that we purchase directly. These risks are especially significant because some of the merchandise we sell on our Websites are characterized by rapid technological change, obsolescence and price erosion (for example, computer hardware, software and consumer electronics), and because we sometimes make large purchases of particular types of inventory. In addition, we often do not receive warranties on the merchandise we purchase. Further, beginning July 1, 2003, we started accepting returns of products sold through our fulfillment partners, and we have the risk of reselling the returned products.

 

In the recent past, we have recorded charges for obsolete inventory and have had to sell certain merchandise at a discount or loss. It is impossible to determine with certainty whether an item will sell for more than the price we pay for it. Because we rely heavily on purchased inventory, our success will depend on our ability to liquidate our inventory rapidly, the ability of our buying staff to purchase inventory at attractive prices relative to its resale value and our ability to manage customer returns and the shrinkage resulting from theft, loss and misrecording of inventory. If we are unsuccessful in any of these areas, we may be forced to sell our inventory at a discount or loss.

 

We have grown quickly and if we fail to manage our growth, our business will suffer.

 

We have rapidly and significantly expanded our operations, and anticipate that further significant expansion will be required to address potential growth in our customer base and market opportunities. This expansion has placed, and is expected to continue to place, a significant strain on our management, operational and financial resources. Some of our officers have no prior senior management experience at public companies. Our new employees include a number of key managerial, technical and operations personnel, and we expect to add additional key personnel in the future. To manage the expected growth of our operations and personnel, we will be required to improve existing and implement new transaction-processing, operational and financial systems, procedures and controls, and to expand, train and manage our already growing employee base. If we are unable to manage growth effectively, our business, prospects, financial condition and results of operations will be harmed.

 

The loss of key personnel or any inability to attract and retain additional personnel could affect our ability to successfully grow our business.

 

Our performance is substantially dependent on the continued services and on the performance of our senior management and other key personnel, particularly Patrick M. Byrne, our Chief Executive Officer. Our performance also depends on our ability to retain and motivate other officers and key employees. The loss of the services of any of our executive officers or other key employees for any unforeseen reason, including without limitation, illness or call to military service, could harm our business, prospects, financial condition and results of operations. We do not have employment agreements with any of our key personnel and we do not maintain “key person” life insurance policies. Our future success also depends on our ability to identify, attract, hire, train, retain and motivate other highly-skilled technical, managerial, editorial, merchandising, marketing and customer service personnel. Competition for such personnel is intense, and we cannot assure you that we will be able to successfully attract, assimilate or retain sufficiently qualified personnel. Our failure to retain and attract the necessary technical, managerial, editorial, merchandising, marketing and customer service personnel could harm our revenues, business, prospects, financial condition and results of operations.

 

We may be unable to manage expansion into new business areas which could harm our business operations and reputation.

 

Our long-term strategic plan involves expansion of our operations to offer additional types of products and services. We cannot assure you that our efforts to expand our business in this manner will succeed. Because we were unable to generate significant traffic for our former B2B site, in the third quarter of 2004, we merged the B2B site into our main website, and opened our Wholesale bulk purchase program. Our failure to succeed in this market or other markets or other product or service offerings may harm our business, prospects, financial condition and results of operation. We cannot assure you that we will be able to expand our operations in a cost-effective or timely manner or that our efforts to expand will be successful. Furthermore, any new business or Website we launch that is not favorably received by consumers could damage our reputation or the Overstock.com brand. We may expand the number of categories of products we carry on our Websites and these and any other expansions of our operations would also require significant additional expenses and development and would strain our management, financial and operational resources. The lack of market acceptance of such efforts or our inability to generate satisfactory revenues from such expanded services or products to offset their cost could harm our business, prospects, financial condition and results of operations.

 

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We may expand our international business, causing our business to become increasingly susceptible to numerous international business risks and challenges that could affect our profitability.

 

We have begun to expand into international markets, and in the future we may do so more aggressively. International sales and transactions are subject to inherent risks and challenges that could adversely affect our profitability, including:

 

      the need to develop new supplier and manufacturer relationships;

 

      the need to comply with additional laws and regulations to the extent applicable;

 

      unexpected changes in international regulatory requirements and tariffs;

 

      difficulties in staffing and managing foreign operations;

 

      longer payment cycles from credit card companies;

 

      greater difficulty in accounts receivable collection;

 

      potential adverse tax consequences;

 

      price controls or other restrictions on foreign currency; and

 

      difficulties in obtaining export and import licenses.

 

To the extent we generate international sales and transactions in the future, any negative impact on our international operations could negatively impact our business. In particular, gains and losses on the conversion of foreign payments into United States dollars may contribute to fluctuations in our results of operations and fluctuating exchange rates could cause reduced gross revenues and/or gross margins from non-dollar-denominated international sales.

 

In order to obtain future revenue growth and achieve and sustain profitability we will have to attract customers on cost-effective terms.

 

Our success depends on our ability to attract customers on cost-effective terms. We have relationships with online services, search engines, directories and other Websites and e-commerce businesses to provide content, advertising banners and other links that direct customers to our Websites. We rely on these relationships as significant sources of traffic to our Websites and to generate new customers. If we are unable to develop or maintain these relationships on acceptable terms, our ability to attract new customers and our financial condition could be harmed. In addition, certain of our online marketing agreements may require us to pay upfront fees and make other payments prior to the realization of the sales, if any, associated with those payments. Accordingly, if these agreements or similar agreements that we may enter into in the future fail to produce the sales that we anticipate, our results of operations will be adversely affected. We cannot assure you that we will be able to increase our revenues, if at all, in a cost-effective manner. We periodically conduct national television and radio branding and advertising campaigns. Such campaigns are expensive and may not result in the cost effective acquisition of customers.

 

Further, many of the parties with which we may have online-advertising arrangements could provide advertising services for other online or traditional retailers and merchandise liquidators. As a result, these parties may be reluctant to enter into or maintain relationships with us. Failure to achieve sufficient traffic or generate sufficient revenue from purchases originating from third parties may result in termination of these relationships by these third parties. Without these relationships, our revenues, business, prospects, financial condition and results of operations could suffer.

 

We may not be able to compete successfully against existing or future competitors.

 

The online liquidation services market is new, rapidly evolving and intensely competitive. Barriers to entry are minimal, and current and new competitors can launch new Websites at a relatively low cost. Our consumer Website currently competes with:

 

      liquidation e-tailers such as SmartBargains;

 

      online retailers with discount departments such as Amazon.com, Inc., eBay, Inc. and Buy.com, Inc.; and

 

      traditional retailers and liquidators such as Ross Stores, Inc., Walmart Stores, Inc., TJX Companies, Inc., Costco Wholesale Corporation, Target Corporation and Best Buy Co., Inc., which may or may not also have an online presence.

 

Our Website competes with liquidation “brokers” and retailers and online marketplaces such as eBay, Inc.

 

We expect the online liquidation services market to become even more competitive as traditional liquidators and online retailers continue to develop services that compete with our services. In addition, manufacturers and retailers may decide to create their own Websites to sell their own excess inventory and the excess inventory of third parties. Competitive pressures

 

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created by any one of our competitors, or by our competitors collectively, could harm our business, prospects, financial condition and results of operations.

 

Further, as a strategic response to changes in the competitive environment, we may from time to time make certain pricing, service or marketing decisions or acquisitions that could harm our business, prospects, financial condition and results of operations. For example, to the extent that we enter new lines of businesses such as third-party logistics, or discount brick and mortar retail, we would be competing with large established businesses such as APL Logistics, and Ltd., Ross Stores, Inc., respectively. We have recently entered the online auctions business in which we compete with large established businesses including eBay, Inc.

 

Many of our current and potential competitors described above have longer operating histories, larger customer bases, greater brand recognition and significantly greater financial, marketing and other resources than we do. In addition, online retailers and liquidation e-tailers may be acquired by, receive investments from or enter into other commercial relationships with larger, well-established and well-financed companies. Some of our competitors may be able to secure merchandise from manufacturers on more favorable terms, devote greater resources to marketing and promotional campaigns, adopt more aggressive pricing or inventory availability policies and devote substantially more resources to Website and systems development than we do. Increased competition may result in reduced operating margins, loss of market share and a diminished brand franchise. We cannot assure you that we will be able to compete successfully against current and future competitors.

 

Our operating results depend on our Websites, network infrastructure and transaction-processing systems. Capacity constraints or system failures would harm our business, prospects, results of operations and financial condition.

 

Any system interruptions that result in the unavailability of our Websites or reduced performance of our transaction systems would reduce our transaction volume and the attractiveness of the services that we provide to suppliers and third parties and would harm our business, prospects, operating results and financial condition.

 

We use internally developed systems for our Websites and certain aspects of transaction processing, including customer profiling and order verifications. We have experienced periodic systems interruptions due to server failure, which we believe will continue to occur from time to time. If the volume of traffic on our Websites or the number of purchases made by customers substantially increases, we will need to further expand and upgrade our technology, transaction processing systems and network infrastructure. We have experienced and expect to continue to experience temporary capacity constraints due to sharply increased traffic during sales or other promotions and during the holiday shopping season. Capacity constraints can cause unanticipated system disruptions, slower response times, and degradation in levels of customer service, impaired quality and delays in reporting accurate financial information.

 

Our transaction processing systems and network infrastructure may be unable to accommodate increases in traffic in the future. We may be unable to project accurately the rate or timing of traffic increases or successfully upgrade our systems and infrastructure to accommodate future traffic levels on our Websites. In addition, we may be unable to upgrade and expand our transaction processing systems in an effective and timely manner or to integrate any newly developed or purchased functionality with our existing systems. For example, in the third quarter 2005 we experienced difficulties with our implementation of infrastructure upgrades, which resulted in our inability to upload new products to our website for a period of approximately five weeks. Any such difficulties with our transaction processing systems or other difficulties upgrading, expanding or integrating various aspects of our systems may cause unanticipated system disruptions, slower response times, and degradation in levels of customer service, additional expense, impaired quality and speed of order fulfillment or delays in reporting accurate financial information.

 

If the facilities where substantially all of our computer and communications hardware is located fail, our business, results of operations and financial condition will be harmed.

 

Our success, and, in particular, our ability to successfully receive and fulfill orders and provide high-quality customer service, largely depends on the efficient and uninterrupted operation of our computer and communications systems. Substantially all of our computer and communications hardware is located at a single co-location facility in Salt Lake City, Utah, with a partially redundant back-up system located at our corporate headquarters in Salt Lake City. Although we have designed our back-up system in an effort to avoid or minimize service interruptions in the event of a failure of our main facility, our systems and operations are vulnerable to damage or interruption from fire, flood, power loss, telecommunications failure, terrorist attacks, acts of war, break-ins, earthquake and similar events. We do not have a formal disaster recovery plan and our business interruption insurance may be insufficient to compensate us for losses that may occur. Despite the implementation of network security measures, our servers are vulnerable to computer viruses, physical or electronic break-ins and similar disruptions, which could lead to interruptions, delays, loss of critical data or the inability to accept and fulfill customer orders. The occurrence of any of the foregoing risks could harm our business, prospects, financial condition and results of operations.

 

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We may be unable to protect our proprietary technology or keep up with that of our competitors.

 

Our success depends to a significant degree upon the protection of our software and other proprietary intellectual property rights. We may be unable to deter misappropriation of our proprietary information, detect unauthorized use and take appropriate steps to enforce our intellectual property rights. In addition, our competitors could, without violating our proprietary rights, develop technologies that are as good as or better than our technology.

 

Our failure to protect our software and other proprietary intellectual property rights or to develop technologies that are as good as our competitors’ could put us at a disadvantage to our competitors. In addition, the failure of the third parties whose products we offer for sale on our Websites to protect their intellectual property rights, including their domain names, could impair our operations. These failures could harm our business, results of operations and financial condition.

 

If we do not respond to rapid technological changes, our services could become obsolete and we could lose customers.

 

To remain competitive, we must continue to enhance and improve the functionality and features of our e-commerce businesses. We may face material delays in introducing new services, products and enhancements. If this happens, our customers may forgo the use of our Websites and use those of our competitors. The Internet and the online commerce industry are rapidly changing. If competitors introduce new products and services using new technologies or if new industry standards and practices emerge, our existing Websites and our proprietary technology and systems may become obsolete. Our failure to respond to technological change or to adequately maintain, upgrade and develop our computer network and the systems used to process customers’ orders and payments could harm our business, prospects, financial condition and results of operations.

 

We may not be able to obtain trademark protection for our marks, which could impede our efforts to build brand identity.

 

We have filed trademark applications with the Patent and Trademark Office seeking registration of certain service marks and trademarks. There can be no assurance that our applications will be successful or that we will be able to secure significant protection for our service marks or trademarks in the United States or elsewhere as we expand internationally. Our competitors or others could adopt product or service marks similar to our marks, or try to prevent us from using our marks, thereby impeding our ability to build brand identity and possibly leading to customer confusion. Any claim by another party against us or customer confusion related to our trademarks, or our failure to obtain trademark registration, could negatively affect our business.

 

We may not be able to enforce protection of our intellectual property rights under the laws of other countries.

 

As we continue to expand internationally, we are subject to risks of doing business internationally as related to our intellectual property, including:

 

      legal uncertainty regarding liability for the listings and other content provided by our users, including uncertainty as a result of less Internet-friendly legal systems, unique local laws, and lack of clear precedent or applicable law; and

 

      differing intellectual property laws, which may provide insufficient protection for our intellectual property.

 

Our business and reputation may be harmed by the listing or sale of pirated, counterfeit or illegal items by third parties, and by intellectual property litigation.

 

We have received in the past, and we anticipate we will receive in the future, communications alleging that certain items listed or sold through our Websites infringe third-party copyrights, trademarks and trade names or other intellectual property rights or that we have otherwise infringed third parties’ past, current or future intellectual property rights. For example, in October 2003, Tiffany (NJ) Inc. and Tiffany and Company filed a complaint against us in the United States District Court for the Southern District of New York alleging that we have distributed counterfeit and otherwise unauthorized Tiffany product in violation of federal copyright and trademark law and related state laws. In addition, in January and February 2005, Tiffany filed additional complaints against us asserting similar claims. We have recently reached an agreement in principle which will settle and dismiss all of the cases. We are currently working on a definitive settlement agreement with Tiffany.

 

We may be unable to prevent third parties from listing unlawful goods, and we may be subject to allegations of civil or criminal liability for unlawful activities carried out by third parties through our Websites. In the future, we may implement measures to protect against these potential liabilities that could require us to spend substantial resources and/or to reduce revenues by discontinuing certain service offerings. Any costs incurred as a result of liability or asserted liability relating to the sale of unlawful goods or the unlawful sale of goods could harm our revenues, business, prospects, financial condition and results of operations.

 

Resolving litigation or claims regarding patents or other intellectual property, whether meritorious or not, could be costly, time-consuming, cause service delays, divert our management and key personnel from our business operations, require

 

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expensive or unwanted changes in our methods of doing business or require us to enter into costly royalty or licensing agreements, if available. As a result, these claims could harm our business.

 

Negative publicity generated as a result of the foregoing could damage our reputation, harm our business and diminish the value of our brand name.

 

Gradient Analytics and Rocker Partners, L.P. Litigation

 

In August 2005 we filed an unfair business practice lawsuit against Gradient Analytics, Rocker Partners, L.P. and others, alleging that the defendants have conspired to denigrate Overstock’s business for personal profit. In October 2005 we filed an amended complaint alleging additional causes of action and articulating in greater detail the allegations against the defendants. Overstock’s President, Dr. Patrick Byrne, has appeared on nationally syndicated television programs and elsewhere to discuss the litigation. The use of management’s time and attention in connection with the litigation and related matters may reduce the time management is able to spend on other aspects of our business, which may have adverse effects on other aspects of our business. To the extent that any such adverse effects exceed any benefits we may realize from pursuing the litigation, our business, prospects, financial condition and results of operation may suffer.