OSTK - Overstock.com

[Ballinvarosig Investors]

Overstock.com (O.co): Is Insolvency Looming?

Overstock.com (NASDAQ:OSTK), also known as O.co, faces possible insolvency if current earnings trends continue and it cannot restructure two loans with U.S. Bank, its biggest creditor by March 31, 2012 at the latest. In an apparent effort to mask its weakening net working capital position, it played a shell game to window dress its balance sheet at the end of the third quarter (September 30, 2011). Overstock.com owed U.S. Bank $20.329 million under the “Master Lease Agreement” (sale-leaseback) and another $17 million under a “Financing Agreement” (line of credit). Therefore, the company owes U.S. Bank $37.329 million under two loan agreements.

Last week Overstock.com surprised investors by reporting a third quarter $7.8 million net loss (diluted earnings per share of negative $0.33) compared to a net loss of $3.4 million (diluted earnings per share of negative $0.15) in the previous year’s third quarter. Its net loss was $0.10 per share higher than was projected by Wall Street analysts. So far, Overstock.com has lost $16 million in the first nine months of the year compared to only a $1.1 million dollar loss during the previous year's nine month period.

"Likely" breach of debt covenant buried in footnotes

As I described in my last blog post, the company buried news of an impending default in its Master Lease Agreement (sale leaseback) with U.S. Bank on page 43 of its footnotes in its third quarter 10-Q report. The Master Lease Agreement with U.S. Bank requires Overstock.com "…to maintain a minimum Total Fixed Charge Coverage annualized ratio of at least 1.20:1.00, based on operating results, measured at the end of each fiscal quarter." The company revealed that, "… based on the results for the first three quarters of 2011, it is likely that we will be out of compliance with the Total Fixed Charge Coverage ratio at December 31, 2011 unless current trends improve substantially. We have held initial and collegial discussions with U.S. Bank regarding this potential non-compliance."

The 10-Q report gives a peek into Overstock.com’s "current trends" and since it was filed 27 days into the 92 day fourth quarter. According to the company’s own analysis, the projected fourth quarter numbers don’t look good “unless current trends improve substantially” in the next few weeks.

Window dressing its balance sheet

At the end of its third quarter, the Overstock.com had $18.4 million of net working capital (current assets minus current liabilities). However, the company would have reported a mere $1.4 million of net working capital had it not played a shell game and window dressed its balance sheet during the third quarter. Apparently, the company wanted to avoid reporting dangerously low net working capital going into the fourth quarter, while at the same time it is trying to renegotiate terms of its Master Lease Agreement (sale leaseback) with U.S. Bank.

On September 21, 2011, Overstock.com borrowed $17 million under its Financing Agreement (line of credit) with U.S. Bank and used $7.5 million of internal cash to redeem $24.5 million of convertible debt before its December 1, 2011 due date (10-Q report page 16 and 33). It could have waited until the fourth quarter to redeem its convertible debt when it was due. Further, the convertible debt was unsecured debt, while the amount it borrowed from U.S. Bank is secured debt.

The convertible debt was classified on the company's balance sheet as a current liability at the end of its second quarter. The $17 million that it borrowed under its Financing Agreement (line of credit) is a long term debt (noncurrent liability) because payment is due on December 31, 2012 (10-Q report page 42). The company used secured long term debt (noncurrent liability) to replace an unsecured current liability in the quarter before its payment was due.

Had Overstock.com not borrowed that $17 million from U.S. Bank to redeem its convertible debentures before the end of the third quarter (September 30, 2011), it would have ended the quarter with a mere $1.4 million in working capital (current assets less current liabilities). In any case, its balance sheet window dressing is temporary, since the $17 million it borrowed will become a current liability by the end of the first quarter of 2012 (March 31, 2012) which is traditionally a weak quarter for the company.

Liquidity issues

At the end of the third quarter (September 30, 2011), Overstock.com owed U.S. Bank $20.329 million under its Master Lease Agreement (sale leaseback). As I detailed above, the company revealed that if current trends don’t "substantially improve" it "likely" won't be in compliance with certain minimum financial benchmarks required under the agreement. According to the Master Lease Agreement, an "Event of Default" includes the "...failure of Lessee to perform any term, covenant or condition of the Lease...." In such a case, if the company cannot restructure its Master Lease Agreement with U.S. Bank, the lender can require the company to immediately pay "…the entire amount of rent and other sums…."

$14.485 million of the $20.329 million Overstock.com owed U.S. Bank under its Master Lease Agreement (sale leaseback) was classified as long term debt (noncurrent liability) as of the end of the third quarter (September 30, 2011). As I detailed above, Overstock.com had only $18.4 million of net working capital at the end of the third quarter. By window dressing its balance sheet, the company made it appear that it had adequate net working capital to pay all amounts due under that agreement in the event of a potential default. Even if we set aside the window dressing issue, the company barely had enough net working capital to pay all amounts due under the Master Lease Agreement in the event of a potential default.

The company is required to have $30 million in compensating balances deposited at U.S. Bank against its Master Lease Agreement (sale leaseback) and Financing Agreement (line of credit). Excluding those $30 million compensating cash balances, the company had only $95.8 million of current assets available to cover $101.6 million of current liabilities as of the end of its third quarter. (Note: The $101.6 million current liabilities amount excludes $5.8 million of current liabilities under the Master Lease Agreement).

In other words, Overstock.com could have a difficult time paying debts as they come due if continues to maintain $30 million in compensating cash balances at U.S. Bank. Further, the $17 million it borrowed under the Financing Agreement becomes classified at a current liability in the first quarter of 2012 which will reduce net working capital by the same amount.

Overstock.com may have to reduce its $30 million of compensating balances on deposit with U.S. Bank. However, if the company does not maintain its compensating balances with U.S. Bank it would default on both loan agreements totaling $37.3 million. Therefore, Overstock.com also may have to renegotiate its Financing Agreement (line of credit) with U.S. Bank.

Other issues

Overstock.com also has to contend with an ongoing investigation by the Securities and Exchange Commission into securities law violations after this blog exposed it fabricating its earnings. So far, every single financial report issued from its inception to Q3 2009 had to be restated up to three times due to violations of Generally Accepted Accounting Principles.

The company is being sued by District Attorneys from seven California District Attorneys who are alleging consumer fraud. They are seeking at least $15 million of restitution, fines, penalties, and cost reimbursements from the company for allegedly defrauding consumers. The Judge in that case had to compel an uncooperative Overstock.com to turn over information to the California District Attorneys.

Earlier in the year, Google penalized Overstock.com for improperly gaming its search algorithm to boost its search rankings.

Two weeks ago, Overstock.com CEO Patrick Byrne, Deep Capture LLC, and Mark Mitchell, a writer for Deep Capture, were sued in a Canadian court for defamation. Deep Capture LLC is an affiliate of Overstock.com and its website was used to promote Byrne's delusional conspiracy theories and libel company critics. The judge ordered the Deep Capture website shut down.

Written by,

Sam E. Antar

Read more: http://www.businessinsider.com/overstockcom-oco-is-insolvency-looming-2011-10#ixzz1cUpMHsPN

[beerbaron]

Why would anybody read Sam Altar's comments?

BeerBaron

[Tim Eriksen]

Why would anybody read Sam Altar's comments?

BeerBaron

I felt the same way about Deep Capture.  That is what makes this interesting.  Its kind of like watching two people you don't like fight. 

[Parsad]

Probably not a good idea to short a company (that in the worst case scenario would need $35M), where the CEO is worth $50M, his father is worth over a billion, and the largest shareholders manage over $22B in investment capital...Prem and Francis! 

Do you really think that if Byrne called up Prem or Francis and offered them convertible notes, or even better preferred shares with a decent yield, that they wouldn't jump on it?  Not to mention that a principal of Hamblin-Watsa, Sam Mitchell, sits on the board of Overstock. 

Hopefully, Sam Antar and his cronies decide to short the hell out of this, because I would be thoroughly entertained to watch them lose all of their money!  Cheers!

[Ballinvarosig Investors]

I'm not actually short by the way! I just posted this because the stock hit a new 52 week low and I was looking to stimulate some discussion!

[kumar]

Probably not a good idea to short a company (that in the worst case scenario would need $35M), where the CEO is worth $50M, his father is worth over a billion, and the largest shareholders manage over $22B in investment capital...Prem and Francis!.... 

My thoughts were exactly on the same lines. We can be sure shorts are also aware of it. What I fail to understand is why shorts are so adamant?

[ValueCarl]

As the result of personal experience with a security on the receiving end of Watsa, Chou's lending practices, I think I will short OVERSTOCK myself should they become the loaners of last resort! 

[stahleyp]

Sanj,

You follow the company way more than I do. What do you think about his allegations?

[Parsad]

Those debt covenants will be breached on a 4 quarter rolling basis.  But they will probably be back within that range after the 4th quarter of 2011, once those receivables come in during the 1st quarter 2012.  Antar will take anything he can and try to blow it up into a huge mess.  Overstock has enough cash to just pay the debt off entirely after the 4th quarter when they get their biggest inflows of operating cash flow. 

Overstock needs to do better...no doubt about that...but to blow it up into what Antar's saying is silly.  They are currently in negotiations with U.S. bank regarding the covenants, and I suspect that some adjustment will occur where U.S. bank will give them some leeway, with them returning to within the credit covenants in the next six months. 

The whole Google penalty and then Overstock's decision to switch to the O.co brand is what really hurt them this year.  They lost about 5% of their revenue in the 1st quarter because of the penalty, and their visibility naturally went down in the 2nd because of that as well.  The stupid idea of ramping up the O.co brand was poorly executed, and Byrne stated that himself in the latest conference call.  Customers were confused and probably put off by the push.  Overstock's own brand is pretty darn good, and there was no reason to switch.  They could have just used the O.co url as an alternative.  Cheers!   

[DCG]

The stupid idea of ramping up the O.co brand was poorly executed, and Byrne stated that himself in the latest conference call.  Customers were confused and probably put off by the push.  Overstock's own brand is pretty darn good, and there was no reason to switch.  They could have just used the O.co url as an alternative. 

I'd have a hard time trusting management that actually thought the whole O.co thing was a good idea.