Overstock.com 10-Q 2005
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
Commission file number: 000-49799
(Exact name of registrant as specified in its charter)
6350 South 3000 East
Salt Lake City, Utah 84121
(Address, including zip code, of
6350 South 3000 East
Salt Lake City, Utah 84121
Registrants 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 an accelerated filer (as defined in Exchange Act Rule 12b-2).
Yes ý No o
Indicate by check mark whether the registrant is a shell company (as defined in Exchange Act Rule 12b-2)
Yes o No ý
There were 19,306,046 shares of the Registrants common stock, par value $0.0001, outstanding on November 7, 2005.
TABLE OF CONTENTS
The accompanying notes are an integral part of these consolidated financial statements.
(in thousands, except per share data)
The accompanying notes are an integral part of these consolidated financial statements.
The accompanying notes are an integral part of these consolidated financial statements.
The accompanying notes are an integral part of these 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 Managements 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, 2004. 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 managements 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 and nine months ended September 30, 2005 are not necessarily indicative of the results to be expected for any future period or the full fiscal year.
2. ACCOUNTING POLICIES
SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities (SFAS No. 133) requires companies to recognize their derivative instruments, including certain derivative instruments embedded in other contracts, as either assets or liabilities in the balance sheet at fair value. The accounting for changes in the fair value of a derivative instrument depends on whether the instrument has been designated and qualifies as part of a hedging relationship and further, on the type of hedging relationship. For those derivative instruments that are designated and qualify as hedging instruments, a company must designate the hedging instrument, based upon the exposure being hedged, as a fair value hedge, a cash flow hedge or a hedge of a net investment in an international operation. For derivatives designated as hedges, the changes in fair value are recorded in the balance sheet as an item in other comprehensive income. Changes in the fair value of derivatives not designated as hedges are recorded in the statement of operations. As of September 30, 2005, the Company had not designated any derivative instruments as hedges.
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 $9.0 million and $17.2 million during the three months ended September 30, 2004 and 2005, respectively, and $19.5 million and $47.7 million during the nine months ended September 30, 2004 and 2005, respectively.
Asset Retirement Obligation
In accordance with SFAS No. 143, Accounting for Asset Retirement Obligations, the Company establishes assets and liabilities for the present value of estimated future costs to return certain of our leased facilities to their original condition. Such assets are depreciated over the lease period into operating expense, and the recorded liabilities are accreted to the future value of the estimated restoration costs. At September 30, 2005, such amounts are not significant.
Accounting for merchant and agency revenues for Travel subsidiary
The determination of gross versus net revenue presentation is based principally on the Companys 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 the Companys 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 principle factor in determining gross versus net presentation by the Companys travel subsidiary, OTravel.com, Inc.
(OTravel.com see Note 4) is 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 noncancelable, and require no significant post-delivery obligations for OTravel.com. A reserve for chargebacks 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.
Recent accounting pronouncements
In March 2005, the Financial Accounting Standards Board (FASB) issued FIN 47 which clarifies guidance provided by Statement No. 143, Accounting for Asset Retirement Obligations. FIN 47 is effective for the Company beginning the quarter ending March 31, 2006. The adoption of FIN 47 is not expected to have a significant impact on the Companys financial position, results of operations or cash flows.
In December 2004, the FASB issued Statement of Financial Accounting Standard (SFAS) No. 123 (revised 2004) Share-Based Payment (Statement 123R). This standard requires companies to measure and recognize the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value. The effective date is the first annual reporting period beginning after June 15, 2005. The Company is currently evaluating pricing models and the transition provisions of this standard and will begin expensing all stock-based compensation in the first quarter of 2006.
On March 29, 2005, the SEC published Staff Accounting Bulletin (SAB) No. 107, which provides the Staffs views on a variety of matters relating to the interaction between Statement 123R and certain Securities and Exchange Commission Rules and regulations. The Company is currently evaluating the provisions of the SAB and will implement it when the Company begins expensing stock options under Statement 123R in the first quarter of 2006.
In March 2004, the FASB issued EITF Issue No. 03-1 (EITF 03-1), The Meaning of Other-than-Temporary Impairments and its Application to Certain Investments, which provides new guidance for assessing impairment losses on investments. Additionally, EITF 03-1 includes new disclosure requirements for investments that are deemed to be temporarily impaired. In September 2004, the FASB delayed the accounting provisions of EITF 03-1; however, the disclosure requirements remain effective for annual periods ending after June 15, 2004. The Company will evaluate the impact of EITF 03-1 once final guidance is issued.
On June 7, 2005, the FASB issued Statement No. 154, Accounting Changes and Error Corrections, a replacement of APB Opinion No. 20, Accounting Changes, and Statement No. 3, Reporting Accounting Changes in Interim Financial Statements (FAS 154). FAS 154 changes the requirements for the accounting and reporting of a change in accounting principle. Previously, most voluntary changes in accounting principles were required to be recognized by way of a cumulative effect adjustment within net income during the period of the change. FAS 154 requires retrospective application to prior periods financial statements, unless it is impracticable to determine either the period-specific effects or the cumulative effect of the change. FAS 154 is effective for accounting changes made in fiscal years beginning after December 15, 2005; however, the Statement does not change the transition provisions of any existing accounting pronouncements. We do not believe adoption of FAS 154 will have a material effect on our consolidated financial position, results of operations or cash flows.
3. MARKETABLE SECURITIES
The Companys marketable securities consist of funds deposited into capital management accounts managed by two financial institutions at September 30, 2005 as follows (in thousands):
All marketable securities mature between 2005 and 2034 and are classified as available-for-sale securities. Available-for-sale securities are classified as current as they are deemed available for use, if needed for current operations.
During the first quarter of 2005, the Company purchased $49.9 million of Foreign Corporate Securities (Notes) which fully mature for $50.0 million in cash in November 2006. The 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 Notes prior to maturity, the Company may not realize the full amount of its initial investment. At September 30, 2005, the Notes had a fair value of $48.2 million.
Under SFAS No. 133, the 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 Notes is recorded as a component of other comprehensive income (loss).
For the quarter and nine months ended September 30, 2005 changes in the value of the conditional coupon resulted in losses of $2.1 million and $2.4, respectively. The changes in the value of the Notes resulted in a gain of $660,000 which was recorded as a component of other comprehensive income (loss) for the quarter and nine months ended September 30, 2005.
The Company purchased the 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 Notes did not qualify as hedging derivative instruments. Nevertheless, management believes that such instruments are useful in managing the Companys associated risk.
On July 1, 2005, the Company acquired all the outstanding capital stock of Ski West, Inc. (Ski West) for an aggregate of $25.1 million (including $111,000 of capitalized acquisition related expenses). In addition, the Company may be subject to additional earn out payments (based on a percentage of operating profits for each of the next four years 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 among the Company, Ski West, and all of the shareholders of Ski West.
Ski West is 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 offerings 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.
Effective upon the closing, Ski West became a wholly-owned subsidiary of the Company, integrated the Ski West travel offerings with the Companys existing travel offerings and changed its name to OTravel.com, Inc.
Purchase Price Allocations
The following table summarizes the estimated fair values of the assets acquired and liabilities assumed on July 1, 2005. The initial purchase price allocations may be adjusted within one year of the purchase date for changes in estimates of the fair value of assets acquired and liabilities assumed (in thousands):
The excess of the purchase price over the fair values of assets acquired and liabilities assumed was allocated to goodwill. Any required earn out payments would further increase goodwill at the time the target operating results for the next four years are successfully achieved. Of the $10,385 recorded in goodwill, the full amount is expected to be deductible for tax purposes, to the extent the Company has sufficient taxable income in the future.
The amounts allocated to intangible assets, and their estimated useful lives, were based on independent appraisal and were attributed to the following categories (in thousands):
During the quarter ended September 30, 2005, the Company recorded amortization expense attributable to the above intangible assets of approximately $700,000.
Pro forma results of operations have not been presented because the effect of the acquisition was not material to the results of prior periods presented.
5. COMPREHENSIVE INCOME (LOSS)
The Company follows SFAS No. 130, Reporting Comprehensive Income. This Statement establishes requirements for reporting comprehensive income and its components. The Companys comprehensive loss for the three and nine months ended September 30, 2004 and 2005 is as follows (in thousands):
6. NET LOSS PER SHARE
Basic 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 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. During the three- and nine-month periods ended September 30, 2004 and 2005, the effects of outstanding stock options, warrants and convertible senior notes were antidilutive and accordingly, have been excluded from diluted loss per share. There were 1.3 million options and no warrants outstanding at September 30, 2005. As of September 30, 2005, the Company had $87.0 million of convertible senior notes outstanding (Note 12), which could potentially convert into 1.2 million shares of common stock in the aggregate.
7. BUSINESS SEGMENTS
Segment information has been prepared in accordance with Financial Accounting Standards Board (FASB) Statement of Financial Accounting Standards (SFAS) No. 131, Disclosures about Segments of an Enterprise and Related Information. There were no inter-segment sales or transfers during the three- or nine-month periods ended September 30, 2004 or 2005. 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 and nine months ended September 30, 2004 and 2005 (in thousands):
The direct segment includes revenues, direct costs, and allocations associated with sales fulfilled from our warehouses. 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 Companys third party fulfillment partner sales and are earned from selling the merchandise of third parties over the Companys Websites. Costs for this segment include product costs, credit card fees and customer service costs. This segment also includes revenues and direct costs associated with our on-line auctions and travel businesses.
Assets have not been allocated between the segments for management purposes, and as such, they are not presented here.
For the three and nine-month periods ended September 30, 2004 and 2005, over 99% of sales were made to customers in the United States of America. No individual geographical area accounted for more than 10% of net sales in any of the periods presented. At December 31, 2004 and September 30, 2005, all of the Companys fixed assets were located in the United States of America.
8. PUBLIC OFFERINGS
In June 2004, the Company closed its second follow-on public offering, pursuant to which it sold 1.3 million shares of common stock, with proceeds to the Company of approximately $37.9 million, net of $405,000 of issuance costs.
In November 2004, the Company closed an additional follow-on public offering, pursuant to which it sold 1.4 million shares of common stock, with proceeds to the Company of approximately $75.2 million, net of $215,000 of issuance costs. Concurrently in November 2004, the Company issued convertible senior notes pursuant to which it received $116.2 million, net of $3.8 million of initial purchasers discount and debt issuance costs.
9. STOCK-BASED COMPENSATION
The Company measures compensation expense to employees for its equity incentive plan using the intrinsic value method prescribed by Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, and provides pro forma disclosures of net income as if the fair value based method prescribed by Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation, had been applied. The following table provides a reconciliation of net loss to pro forma net loss as if the fair value method had been applied to all awards (in thousands)
The fair value of options granted is estimated at the date of grant using the Black-Scholes option pricing model. The Black-Scholes option pricing model requires the input of highly subjective assumptions, including the expected stock price volatility. We use the historical stock price volatility of our common stock over the most recent period that is generally commensurate with the expected option life as the basis for estimating stock price volatility. For options granted during the three months ended September 2005, the historical stock price volatility used was based on a daily stock price observation, using the closing price, which resulted in an expected stock price volatility of 76.43%. For purpose of the above pro forma disclosure, the fair value of options granted is amortized to stock-based employee compensation cost over the period(s) in which the related employee services are rendered. Accordingly, the pro forma stock-based compensation cost for any period will typically relate to options granted in both the current period and prior periods. Effective January 1, 2006, the Company will record stock compensation expense in accordance with FAS 123R.
10. SHARE BUYBACK PROGRAM
During January 2005, the Companys Board of Directors authorized a stock repurchase program under which the Company was authorized to repurchase up to $50.0 million of its common stock through December 31, 2007. On April 26, 2005, the Board of Directors increased the amount of the stock buyback program to $100.0 million. Additionally, on June 14, 2005, the Board of Directors authorized an amendment of its three-year stock repurchase program to include the repurchase of its Convertible Senior Notes.
During 2005, the Company entered into several purchased call options, pursuant to which the Company could have been required to purchase up to 1.3 million shares of its common stock at certain settlement dates during the quarter ended June 30, 2005. In connection with these repurchase transactions; the Company paid approximately $47.5 million, which was recorded in shareholders equity in the consolidated balance sheet.
At the Companys option, the purchased call options were settled in cash or stock, based on the market price of our common stock on the date of the settlement. Upon settlement, the Company either had its capital investment returned with a premium or received shares of its common stock, depending, respectively, on whether the market price of its common stock was above or below a pre-determined price agreed in connection with each such transaction.
Under the buyback program, the Company repurchased approximately 665,000 shares of our common stock in open market transactions for $24.1 million during the nine months ended September 30, 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 nine months ended September 30, 2005. The purchased call options that did not settle in stock settled in cash totaling $7.9 million, which the Company received in July 2005.
In December 2004, the Company entered into an amendment to a credit agreement (Amended Credit Agreement) with Wells Fargo Bank, National Association. The original credit agreement (originally executed in February 2004) provided the Company with a revolving line of credit for the purpose of issuing up to $10.0 million of letters of credit for the purchase of inventory. As amended to date, the Amended Credit Agreement provides a revolving line of credit to the Company of up to $30.0 million and expires December 31, 2005. The Company has the option to renew the Amended Credit Agreement annually. Included in the $30.0 million Amended Credit Agreement is a $15.0 million sub-limit for a revolving line of credit which the Company uses to obtain letters of credit to support inventory purchases.
At September 30, 2005 $4.4 million was outstanding on the line and letters of credit totaling $6.9 million were issued on our
behalf under this facility.
Prior to October 18, 2005, interest on borrowings was payable monthly and accrued at either (i) one-half of one percentage point (0.50%) 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 was due on the maturity date. Borrowings under the facility were collateralized by the Companys cash and marketable securities deposited at Wells Fargo or its affiliates, and the Company was required to maintain balances with Wells Fargo or its affiliates of up to $21.1 million in order to have the full amount of the credit facility available.
The 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 September 30, 2005.
On October 18, 2005, we entered into a sixth amendment to the credit agreement (Sixth Amended Credit Agreement). The Sixth Amended Credit Agreement eliminated the requirement that the Company maintain specified cash balances with Wells Fargo as a condition to the availability of advances under the facility, and substituted collateral consisting of foreign bond securities owned by the Company in an aggregate principal amount of $50.0 million to secure the Companys obligations under the facility. The $15.0 million sub-limit used to obtain letters of credit to support inventory purchases remained the same. We have an option to renew the Sixth Amended Credit Agreement annually. The Sixth Amendment increased the interest rate on fixed rate advances under the credit facility to 1.35% above LIBOR on the first day of each fixed rate term.
The Company leases certain software and computer equipment under three non-cancelable capital leases that expire at various dates through 2008. The Company expects that in the normal course of business the leases will expire. Software and equipment acquired relating to the capital leases were $1.8 million and $16.3 million at December 31, 2004 and September 30, 2005, respectively, with accumulated depreciation and amortization of $395,000 and $2.9 million at those respective dates. Depreciation of assets recorded under capital leases was zero and $2.5 million for the nine months ended September 30, 2004 and 2005, respectively.
Future minimum lease payments under capital leases are as follows (in thousands):
12. 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). This includes $20.0 million of additional Senior Notes issued to the initial purchaser upon exercise of its 30-day purchase option to cover over-allotments. Proceeds to the Company were $116.2 million, net of $3.8 million of initial purchasers 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 three and nine months ended September 30, 2005, the Company recorded amortization of discount and debt issuance costs related to this offering totaling $128,000 and $384,000, respectively. Interest on the Senior Notes is payable semi-annually on June 1 and December 1 of each year, beginning June 1, 2005. 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 Companys 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 the Companys 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 Companys board of directors or the termination of trading of the Companys 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 September 30, 2005.
In June 2005, under the Share Buyback Program (see Note 10), the Company retired $33.0 million of its 3.75% Convertible Senior Notes (the Senior Notes), which were due on December 1, 2011 for $27.9 million in cash. As a result of the note retirement, the Company recognized a gain of $4.2 million, net of the associated unamortized discount of $960,000, in other income, in the consolidated statements of operations. As of September 30, 2005, $87.0 million of the Senior Notes remained outstanding. Pursuant to the Share Buyback Program, the Company had initiated the retirement of additional Convertible Senior Notes as of November 8, 2005.
13. COMMITMENTS AND CONTINGENCIES
Through July 2005, the Company leased 43,000 square feet of office space under an operating lease which was originally scheduled to expire in January 2007. However, effective July 2005 this lease was terminated and replaced with a lease for a new office building in the Old Mill Corporate Center III in Salt Lake City, Utah. Pursuant to this agreement, the Company began leasing approximately 143,000 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 issued a letter of credit for $500,000 to the Lessor.
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 operating leases are as follows (in thousands):