Overstock.com Investor

CEO Owner's Guide

Dear Owner,

I wish to set a gold standard in communicating with candor your firm's results.

As teenagers my brothers and I ran a Christmas tree lot. We cared about reality, not cosmetics, and wanted an accounting system to help us understand and run our business. We devised a system we called, "cigar-box accounting," because at day's end, standing by the trashcan fire, we counted the bills in the cigar box and knew what we had made or lost. It was simple, foolproof, and we made good decisions using it.

Now, as the CEO of Overstock, I want shareholders to understand the economics of their business and the metrics we use to most effectively manage it. Our internal method of accounting is quite straightforward and follows generally accepted accounting principles ("GAAP"), with a few exceptions. In our public SEC filings we chose principles at the conservative edge of GAAP, but I will continue to present and discuss our results as I see them using the internal terms we have grown up with. For your reference, our GAAP and our internal accounting methods are described below with particular attention paid to the similarities and differences between the two.

GAAP METRICS - see SEC filings for greater detail

Revenue is comprised of direct revenue, and fulfillment partner revenue. All revenue amounts are net of returns, chargebacks and fraud, and sales discounts, primarily coupons.

Direct revenue consists of merchandise sales made to individual consumers and businesses, which are fulfilled from our warehouses in Utah.

Fulfillment partner revenueis generated when we sell the merchandise of other retailers, catalogues or manufacturers through our Website. We do not own or physically handle the merchandise for these transactions unless the product is returned. The entities with which we have a third party fulfillment relationship ship the products directly to the end customer. Revenue generated from our auctions and cars tabs is reported on a net basis and is included in fulfillment partner revenue.

Cost of Goods Sold consists primarily of the costs of merchandise sold to customers, fixed warehouse costs, warehouse handling costs, inbound and outbound shipping costs, credit card fees and customer service costs.

Sales and Marketing consist primarily of online and offline advertising, public relations and promotional expenditures, as well as payroll and related expenses for personnel engaged in marketing and selling activities.

General and Administrative consist of wages and benefits for executive, accounting, and administrative personnel, rents and utilities, travel and entertainment, depreciation and amortization and other general corporate expenses.

Technology Expense consist of wages and benefits for technology related personnel, rents and utilities, and depreciation and amortization related to software and computer equipment.

MANAGEMENT METRICS

Gross Merchandise Sales (Gross Bookings for Auctions)

One place where we are internally less conservative than GAAP is in how we think of sales. GAAP recognizes as revenue the full value of goods shipped from our warehouses or our partner's warehouses, less discounts and returns, whereas gross merchandise sales ("GMS") is simply the gross amount of goods shipped. The only difference is that GAAP revenue is reduced by returns and marketing coupons: in our management accounting system these show up in our COGS and marketing expenses respectively, as explained below. Prior to July 1, 2003, the differences were more significant as we were accounting for partner revenue on a net, or commission, basis. From that time, however, we have taken all customer returns at our own facility, which requires us to account for fulfillment partner transactions in the same manner as we would a direct transaction. Revenue for the auctions and cars businesses is accounted for on a net rather than a gross basis.

Core versus Direct, Partner versus Fulfillment Partner

Core sales are those shipped from our warehouses. Partner sales are those that are generated by Overstock, our marketing and merchandising team, and our website, but are those in which goods are drop-shipped directly from our partner to our customer. From the customer's perspective, packages all appear to come from Overstock.com. The SEC and our auditors objected to our internal term, "partner," because it has the connotation (they say) of a legally bound entity, whereas these relationships are quite dynamic. For this reason, in our GAAP terminology we call our core and partner channels "direct" and "fulfillment partner," respectively.

Cost of Goods Sold

Core COGS - Our accounting for core COGS is in-line with GAAP with one exception. Inbound freight, outbound freight, customer service, credit card fees, charge-backs, fraud, and warehouse handling and fixed expenses are all included in our management COGS. Unlike GAAP, however, which nets returns from revenue, we include the cost of returns in our COGS calculation, an explanation of which is below.

Economic Cost of Returns - In our early history returns costs were huge, and fluctuated widely. Stuffing them into a contra against sales both introduced too much noise into many metrics we wished to track as a percent of sales (for example, outbound freight), and tended to camouflage them so that they did not get managed with discipline. As an antidote to this we started thinking in terms of the "economic cost of returns." This calculation, which varies by product, is a fairly complex function of the percentage of units sold that are returned, the percentage of these that are restocked and resold, the percent that are damaged and so cannot be resold but for which we are reimbursed by either the vendor (for selling us damaged product) or the freight company (for damaging it in shipping), handling fees, restocking fees charged, etc. The payoff is that we arrive at a "handicap" for each product with which to burden its COGS.

Partner COGS - As of July 1, 2003, partner COGS include the cost we pay the partner for each product, which is what the partner bills us to cover the cost of the product, as well as their warehousing, handling and fulfillment costs. Additionally, we incur credit card fees and chargebacks for selling the product on the website, as well as customer service costs. As all partner returns are now sent back to our warehouse, partner returns costs are now accounted for by management the same way that we account for core returns costs, as an element of COGS.

Juice

Gross sales less COGS defined as above leaves us the "juice," that is, our marginal gain for making that one additional sale. Juice is comparable to gross profit if you were to subtract coupons and sales discounts.

Marketing and Customer Acquisition

Our customer acquisition numbers capture all marketing expenses, from on-line advertising to our off-line branding campaigns to the salaries and benefits of the people in the marketing department.

Marketing Coupons - There was a day when an Internet company would repeatedly give the same customer $5 coupons to buy $15 bags of dog food, and then book the $15 as revenue. Eventually the Financial Accounting Standards Board ("FASB") stopped this practice, opining that a firm could only book as revenue the amount the customer actually paid ($10 in the above example). I agree that the FASB's decision was a step forward, that if I give a $5 discount coupon to the same customer over and over to make such purchases, then she is not really "spending" $15 each time she comes.

Yet there is a different way to look at some coupons: we are sending a check to Yahoo! this month so that they will generate new customers for us, we are sending checks to MSN and Google this month so that they will generate new customers for us, and we are sending a check (in the form of a $5 discount coupon) this month to someone in Peoria in order to be a new customer for us. I agree that if I send the same "check" over and over to the same woman in Peoria to get repeat business from her then this "check" (i.e., discount coupon) is just revenue I did not collect. But in considering only the underlying economics of first buys, I think I should treat such cases as marketing checks, just like the checks going to Yahoo!, MSN, and Google, and then calculate the efficacy of such checks, doubling up on winners and cutting losers. And since our marketing department uses essentially all its coupons in customer acquisition, and rarely gives a coupon to someone who has already bought from us, our management accounting therefore does not net them against gross bookings, but instead, treats them as an element of marketing spending.

Nectar

"Juice" less marketing expenses leaves us the "nectar", or the amount of gross profit left to cover our fixed costs, or "nut" (see below). On a GAAP basis, this is commonly referred to as contribution, or contribution margin when thinking in terms of percentages.

Nut

Another term from my Christmas tree days was "nut", as in, "Did we cover our nut today?" This includes all employee compensation and benefits (excluding warehouse and marketing staff), warehouse rent and management expenses, corporate and technology expenses, and depreciation and amortization charges. (it baffles me that the "pro forma" accounting of some Internet firms excludes depreciation as an expense: either it was an expense the day you bought it, or over the years that you use it up: at some point you have to admit the cash is gone! "Nut" is akin to G&A under GAAP.

Management Operating Income

With good gross bookings and COGS, and disciplined sales and marketing spend, what is left (nectar) can cover our nut. Anything left after that is management's operating profit. By subtracting any non-cash or other charges from the management operating profit, one gets, as I view it, to GAAP net income.

Conclusion

"Labels are the guests of reality." - Zhuang-ze

What matters in accounting is not always how it is being done, but that the rules by which it is being done are made explicit. As required by law I present our financial results according to GAAP. Beyond that, however, I wish to open our cigar box to you in order to communicate with unprecedented candidness the economics of the business you bought. The system explained above is designed to that end.

Respectfully submitted,
Patrick M. Byrne