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Why is a value investor writing about an unprofitable internet company? Because value investing is about finding dollars that trade for fifty cents; with a market cap of less than 75% of sales, Overstock.com (OSTK) looks like it may be exactly that.

But isn’t it too risky?

The greatest risk in any inv

According to USFDA, a combination product is one composed of any combination of a drug and device; biological product and device; drug and biological product

estment is the risk of overpaying. So, the real question is: what is Overstock worth? I think it’s worth at least $1.5 billion. With Overstock’s market cap currently sitting around $500 million, my valuation certainly looks far fetched. But, there’s only one way to know for sure. Let’s take apart my arg

; or drug, device, and biological product and fixed dose combination would include two or more combinations of drug.

Examples of combination products may in

ument piece by piece, and see if any of my assumptions are unreasonable.

First Assumption: Over the next five years, Overstock will neither generate truly free cash flow nor consume cash. In other words, its free cash flow margin will average 0%. Cash generation in some years will exactly offset cash c

lude drug-coated devices, drugs packaged with delivery devices in medical kits, and drugs and devices packaged separately but intended to be used together.

onsumption in other years. Obviously, this assumption is unreasonable, because there is almost no chance the cash flows will exactly offset.

That’s not a problem if it turns out Overstock does generate some free cash flow over the next five years. In that case, my assumption simply errs on the side of

here is enormous increase in the number of combination products entering the market in the recent years. Combination products have proven advantages but fixe

caution. If, however, it turns out Overstock actually consumes cash over the next five years, there is a problem – possibly a very big problem. So, which scenario is more likely?

Overstock’s revenues are growing quickly. Gross margins look solid at 13.3% in 2004 and 14.9% over the last twelve months. O

d dose combinations are still in the process of convincing regulatory authority on their advantages over the single ingredient formulations.

Combination pro

verstock’s unprofitability is the result of its selling, general, and administrative expenses (SG&A) which have been growing exponentially. Will these expenses continue to grow? Yes, but not as fast as revenues. Over the last twelve months, Overstock’s spending on cap ex has been 5.6% of sales. That num

ucts have become life saving products for the pharmaceutical companies who doesn’t have many innovative molecules in their product pipeline and have been inc

ber is an aberration. In the long run, spending on cap ex should not exceed 3% of sales. Considering the business Overstock is in and the expected sales growth, the company will, more likely than not, generate some free cash flow over the next five years. Therefore, the assumption that Overstock will be

easingly used in the product life cycle management. Even the companies having product patents are trying to extend their product life cycle through the combi

cash flow neutral over the next five years is not overly optimistic.

Second Assumption: Over the next five years, Overstock’s sales will grow by 15% annually. Is this an unreasonable assumption? Again, I don’t think it is. Very few industries are expected to grow as fast as eCommerce. Overstock’s reven

nation products and maximize the revenues. But the companies involved in this practice are overlooking that they are burdening the patients both economically

ue growth in 2003 and 2004 was over 100%. In the past year, that growth has slowed. However, it is still closer to 50% than it is to 15%. Overstock isn’t in a cyclical business. So, there is no reason to believe current sales are abnormally high.

Also, all that spending on advertising is increasing con

and physically. They need to rightly judge the benefits of the combination products and they have to even look at the risks involved when combining the produ

sumers’ awareness of Overstock. A review of Overstock’s traffic data shows it has not only been gaining more visitors; it has also been climbing the ranks of the most popular web sites. While it is a long, long way from the Amazons, Yahoos, and eBays of the world (and will never reach those heights) Ove

ts. Some of the combination products were well accepted by physicians while others suffered. Companies involved in development of combination products are fi

rstock is becoming a well known internet destination. This fact was most clearly evident in the weeks leading up to Christmas. Shoppers who visited Overstock during the holiday season obviously know it exists, and may very well return at some other point in the year. Analysts are predicting very high gr

ding difficulty in defining their combination products and facing various challenges from selecting a combination to marketing it.

Following aspects would a

owth rates for Overstock; however, they are also recommending you sell the stock. I don’t put any weight in their estimates. But, for the other reasons given, I believe the assumption that Overstock will grow sales at 15% a year for the next five years is not unreasonable.

Third Assumption: Six to ten

dd to the challenges in developing combination products:

Which markets to tap where the combination products can do fairly well?
Which combination prod

years from today, Overstock will have a free cash flow margin of 3%. Ten years from today, Overstock’s free cash flow margin will rise to 4% and remain at that level. Now, of all the assumptions I’ve made, this one is the most questionable. Sure, Amazon has that kind of free cash flow margin, but Overst

cts are meaningful and rational?
Which therapeutic categories to select?
Which Combinations can address unmet needs of the patients?
Do combin

ock isn’t Amazon, and it never will be Amazon. Overstock’s gross margins are less than Amazon’s. In fact, Overstock’s gross margins are less than Wal – Mart’s. However, Overstock’s fixed costs will eat up a much smaller portion of its sales than is the case over at Wal - Mart.

If you compare Overstock

tions increase the patient compliance?
What would be the developing cost?
How to tackle the risks encountered during combination product developmen

o other online retailers, you will see that if Overstock does experience strong sales growth, a 3% free cash flow margin six years from now is not unreasonable. I assumed Overstock’s sustainable free cash flow margin will be 4%. There’s a case to be made that 4% is too high. I won’t make that case, beca

t?

As combination products don't fit into the traditional categories of drugs, medical devices, or biological products, the USFDA is in the process of devel

use I don’t believe in it. Remember, that 4% number comes ten years out. That gives Overstock plenty of time to grow sales and thus reduce SG&A as a percentage of sales.

Fourth Assumption: Six to ten years from today, Overstock will be growing sales by 12% a year; eleven to fifteen years from today, Ov

ping new procedures for reviewing their safety, efficacy and quality.

Professional from academic institutions, pharmaceutical industries, health care indust

erstock will be growing sales by 8% a year; thereafter, Overstock will grow sales by 4% a year. Let’s see what this really means. According to these assumptions, Overstock’s sales will be as follows:

Today: $707 million

2011: $1.59 billion

2016: $2.71 billion

2021: $3.83 billion

2026: $4.66 billion

y and representatives from various regulatory agencies are working out to design the regulatory requirements for manufacture and sale of combination products

2031: $5.67 billion

2036: $6.90 billion

Seven billion dollars is not an unreasonable target – if you have thirty years to achieve it. To put that figure in perspective, Amazon.com currently has sales of about $8 billion. So, even after thirty years, these assumptions don’t lead to Overstock reaching

.

As there is an increasing trend of the combination products companies manufacturing such products should be able to tackle the problems involved in the de

the same size as today’s Amazon. Don’t forget these numbers assume some inflation. For instance, if inflation averages 3% a year over the next thirty years, Overstock’s projected $6.90 billion in sales only translates to $2.84 billion in today’s dollars. So, these assumptions only lead to a fourfold in

elopment. They need to be wiser in analyzing the market trends and the regulatory requirements.

Companies that provide selfless information through particip

crease in Overstock’s real sales over a period of thirty years. I think that’s pretty reasonable.

If you take these four assumptions together, you get a value of $1.5 billion for Overstock. Today, Mr. Market is offering it for $500 million – that’s why I’m writing about an unprofitable internet company

tion in industry events and feedback to regulatory authorities would be able to face the challenges and will be successful in developing combination products

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Search engine optimization costs money – usually a lot of money. Find out what you should be considering before you make the investment, write the check, and hope for the best.

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