OVERSTOCK.COM, INC – 10-K – MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Edgar Online, Inc. |
This Annual Report on Form 10-K and the documents incorporated herein by reference contain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. These statements are therefore entitled to the protection of the safe harbor provisions of these laws. These forward-looking statements involve risks and uncertainties, and relate to future events or our future financial or operating performance. The forward-looking statements include all statements other than statements of historical fact, including, without limitation, all statements regarding: º • º the anticipated benefits and risks of our business and plans; º • º our ability to attract and retain customers in a cost-efficient manner; º • º the effectiveness of our marketing; º • º our future operating and financial results; º • º the competition we face and will face in our business; º • º the effects of government regulation; º •
º our future capital requirements and our ability to satisfy our capital
needs; º • º our expectations regarding the adequacy of our liquidity; º • º our ability to retire or refinance our debt; º • º our plans for international markets; º • º our plans for changes to our business; º • º our beliefs regarding current or future litigation or regulatory actions; º • º our beliefs and expectations regarding existing and future tax laws
and related laws and the application of those laws to our business;
º • º our beliefs regarding the adequacy of our insurance coverage; º •
º the adequacy of our infrastructure, including our backup facilities
and our disaster planning;
º •
º our belief that we can meet our published product shipping standards
even during periods of relatively high sales activity; º • º our belief that we can maintain or improve upon customer service levels that we and our customers consider acceptable; º •
º our beliefs regarding the adequacy of our order processing systems and
our fulfillment and distribution capabilities; º • º our beliefs regarding the adequacy of our customer service capabilities; º •
º our beliefs and expectations regarding the adequacy of our office and
warehouse facilities;
º •
º our expectations regarding our travel shopping service, our insurance
shopping service, our international sales efforts, our car listing
service and our community site, and the anticipated functionality and results of operations of any of them; º • º our belief that we and our fulfillment partners will be able to
maintain inventory levels at appropriate levels despite the seasonal nature of our business; and 43
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Table of Contents º • º our belief that we can successfully offer and sell a constantly changing mix of products and services. Furthermore, in some cases, you can identify forward-looking statements by terminology such as may, will, could, should, expect, plan, intend, anticipate, believe, estimate, predict, potential or continue, the negative of such terms or other comparable terminology. These statements are only predictions. Actual events or results may differ materially. In evaluating these statements, you should specifically consider the risks outlined in this Annual Report on Form 10-K for the year endedDecember 31, 2011 , including those described in Item 1A under the caption "Risk Factors." These factors may cause our actual results to differ materially from those contemplated by any forward-looking statement. Except as otherwise required by law, we expressly disclaim any obligation to release publicly any update or revisions to any forward-looking statements to reflect any changes in our expectations or any change in events, conditions or circumstances on which any of our forward-looking statements are based. Although we believe that the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, levels of activity, performance or achievements. 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. Introduction We are an online retailer offering discount brand name, non-brand name and closeout merchandise, including bed-and-bath goods, home décor, kitchenware, furniture, watches and jewelry, apparel, electronics and computers, sporting goods, and designer accessories, among other products. We are also a channel through which customers can purchase cars, insurance and travel products and services. We sell advertising. We also sell hundreds of thousands of best seller and current run books, magazines, CDs, DVDs and video games ("BMMG"). We sell these products and services through our Internet websites located at www.overstock.com, www.o.co and www.o.biz ("Website"). Although our three websites are located at different domain addresses, the technology and equipment and processes supporting the three websites and the process of order fulfillment described herein are the same for all three websites. Our company, based inSalt Lake City, Utah , was founded in 1997. We launched our initial website inMarch 1999 . Our Website offers our customers an opportunity to shop for bargains conveniently, while offering our suppliers an alternative inventory liquidation or sales channel. We continually add new, sometimes limited, inventory products to our Website in order to create an atmosphere that encourages customers to visit frequently and purchase products before our inventory sells out. We sell products primarily inthe United States , with a small amount of products (less than 1% of sales) sold internationally.
As used herein, "Overstock," "
Our Business
We deal primarily in discount, replenishable, and closeout merchandise and we use the Internet to aggregate both supply and demand to create an efficient marketplace for selling these products. We provide manufacturers with a one-stop liquidation channel to sell both large and small quantities of excess, closeout and replenishable inventory without disrupting sales through traditional channels, which can result in weaker pricing and decreased brand strength. The merchandise offered on our Website is from a variety of sources including well-known, brand-name manufacturers. We have organized our shopping business (sales of product offered through the Shopping Section of our Website) into two 44
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principal segments-a "direct" business and a "fulfillment partner" business. We currently offer approximately 251,000 non-BMMG products and approximately 637,000 BMMG products. Consumers and businesses are able to access and purchase our products 24 hours a day from the convenience of a computer, Internet-enabled mobile telephone or other Internet-enabled devices. Our team of customer service representatives assists customers by telephone, instant online chat and e-mail. We also derive revenue from other businesses advertising products or services on our Website. We have car, insurance and travel listing businesses through which cars, insurance and travel-related products and services may be purchased from vendors. Nearly all of our sales are to customers located inthe United States . During the years endedDecember 31, 2011 and 2010 no single customer accounted for more than 1% of our total revenue.
Direct business
Our direct business includes sales made to individual consumers and businesses, which are fulfilled from our leased warehouses inSalt Lake City, Utah . During the year endedDecember 31, 2011 , we fulfilled approximately 16% of our order volume through our warehouses. Our warehouses generally ship between 4,000 and 7,000 orders per day and up to approximately 10,000 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 record revenue from the majority of these sales transactions 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 relationships with approximately 2,000 third parties who supply approximately 242,000 non-BMMG products, as well as most of the BMMG products, on our Website. These third-party fulfillment partners perform essentially the same fulfillment operations as our warehouses, such as order picking and shipping; however, we handle returns and customer service related to substantially all orders placed through our Website. Revenue generated from sales on our Shopping site from both the direct and fulfillment partner businesses is recorded net of returns, coupons and other discounts. Both direct and fulfillment partner revenues are seasonal, with revenues historically being the highest in the fourth quarter, which endsDecember 31 , reflecting higher consumer holiday spending. We anticipate this will continue in the foreseeable future. Generally, we require verification of receipt of payment, or authorization from credit card or other payment vendors whose services we offer to our customers (such as PayPal and BillMeLater), before we ship products to consumers or business purchasers. From time to time we grant credit to our business purchasers with normal credit terms (typically 30 days). For sales in our fulfillment partner business, we generally receive payments from our customers before our payments to our suppliers are due.
International business
We began selling products through our Website to customers outsidethe United States in lateAugust 2008 . As ofDecember 31, 2011 , we were offering products to customers in over 105 countries and non-U.S. territories. We do not have sales operations outsidethe United States , and are using a U.S. based third party to provide logistics and fulfillment for all international orders. Revenue generated from our international business is included in either direct or fulfillment partner revenue, depending on whether the product is shipped from our warehouses or from a fulfillment partner. Less than 1% of our sales are made to international customers. 45
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Consignment
In
Revenue from our consignment service business is less than 1% of total net revenue and is included in the fulfillment partner segment.
Other businesses
We operate an online car listing service as part of our Website. The car listing service allows sellers to list vehicles for sale and allows buyers to review vehicle descriptions, post offers to purchase, and provides the means for purchasers to contact sellers for further information and negotiations on the purchase of an advertised vehicle. We also earn advertisement revenue derived from our cars business. Revenue from the cars businesses is included in the fulfillment partner segment on a net basis. We operate an online site, O.biz, a website where customers and businesses can shop for bulk and business related items, while offering manufacturers, distributors and other retailers an alternative sales channel for liquidating their inventory. Revenue generated from our O.biz is included in either direct or fulfillment partner revenue, depending on whether the product is shipped from our warehouses or from a fulfillment partner.
In
InJuly 2011 , we began operating an insurance shopping service as part of our Website where customers can shop for auto and home insurance and compare quotes from various insurance providers. We also earn advertisement revenue from our insurance business. Revenue generated from our insurance shopping site is included in the fulfillment partner segment on a net basis. Prior toJuly 2011 , we operated an online auction service as part of our Website. InJuly 2011 , we removed our Marketplace tab for auctions from our Website and no longer provide auction services. The financial results and related assets of the online auction service were not significant to our business. Our Marketplace tab allowed sellers to list items for sale, buyers to bid on items of interest, and users to browse through listed items online. We recorded only our listing fees and commissions for items sold as revenue. From time to time, we also sold items returned from our shopping business through our auction service, and for these sales, we recorded the revenue on a gross basis. Revenue from the auctions is included in the fulfillment partner segment. Prior toJune 2011 , we operated an online site for listing real estate for sale as part of our Website. InJune 2011 , we removed our online site for listing real estate for sale from our Website and no longer provide these real estate listing services. The financial results and related assets of the online site for listing real estate for sale were not significant to our business. The real-estate listing service allowed customers to search active listings across the country. Revenue from the real estate business is included in the fulfillment partner segment on a net basis. Prior toJune 2011 , we operated Eziba.com, a private sale website featuring home décor products, jewelry, apparel and accessories from many leading brands. InJune 2011 , we turned off the Eziba.com website; however, we continue to sell the type of products that were listed on Eziba.com through our websites, O.co andOverstock.com .
Revenue from our other businesses is less than 1% of total net revenues.
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Critical Accounting Policies and Estimates
The preparation of financial statements in conformity with U.S. generally accepted accounting principles ("GAAP") requires estimates and assumptions that affect the reported amounts of assets and liabilities, revenues and expenses, and related disclosures of contingent assets and liabilities in the consolidated financial statements and accompanying notes.The Securities and Exchange Commission ("SEC") has defined a company's critical accounting policies as the ones that are most important to the portrayal of the company's financial condition and results of operations, and which require the company to make its most difficult and subjective judgments, often as a result of the need to make estimates of matters that are inherently uncertain. Based on this definition, we have identified the critical accounting policies, estimates and judgments addressed below. We also have other key accounting policies, which involve the use of estimates, judgments, and assumptions that are significant to understanding our results. For additional information, see Item 1 of Part I, "Financial Statements"-Note 2-"Accounting Policies." Although we believe that our estimates, assumptions, and judgments are reasonable, they are based upon information presently available. Actual results may differ significantly from these estimates. Our critical accounting policies are as follows: º • º revenue recognition; º •
º estimating valuation allowances and accrued liabilities (specifically,
the allowances for returns, credit card chargebacks, doubtful accounts
and obsolete and damaged inventory);
º •
º internal use software and website development (acquired and developed
internally); º • º accounting for income taxes; º • º valuation of long-lived and intangible assets and goodwill; and º • º loss contingencies.
Revenue recognition
We derive our revenue primarily from two sources: direct revenue and fulfillment partner revenue, including listing fees and commissions collected from products being listed and sold through the Auctions tab, which we removed from our site inJuly 2011 , advertisement revenue derived from our real estate listing business, which we removed from our site inJune 2011 , from our cars listing business, and from advertising on our shopping, travel and insurance pages. We have organized our operations into two principal segments based on the primary source of revenue: direct revenue and fulfillment partner revenue. Revenue is recognized when the following revenue recognition criteria are met: (1) persuasive evidence of an arrangement exists; (2) delivery has occurred or the service has been provided; (3) the selling price or fee revenue earned is fixed or determinable; and (4) collection of the resulting receivable is reasonably assured. Revenue related to merchandise sales is recognized upon delivery to our customers. As we ship high volumes of packages through multiple carriers, it is not practical for us to track the actual delivery date of each shipment. Therefore, we use estimates to determine which shipments are delivered and, therefore, recognized as revenue at the end of the period. Our delivery date estimates are based on average shipping transit times, which are calculated using the following factors: (i) the type of shipping carrier (as carriers have different in-transit times); (ii) the fulfillment source (either our warehouses or those of our fulfillment partners); (iii) the delivery destination; and (iv) actual transit time experience, which shows that delivery date is typically one to eight business days from the date of shipment.
We review and update our estimates on a quarterly basis based on our actual transit time experience. However, actual shipping times may differ from our estimates.
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The following table shows the effect that hypothetical changes in the estimate of average shipping transit times would have had on the reported amount of revenue and net loss for the year endedDecember 31, 2011 (in thousands): Year ended December 31, 2011 Increase (Increase) (Decrease) Decrease Net Change in the Estimate of Average Transit Times (Days) Revenue Loss 2 $ (8,537 ) $ (1,116 ) 1 $ (6,073 ) $ (821 ) As reported As reported As reported -1 $ 4,310 $ 537 -2 $ 7,138 $ 913 When we are the primary obligor in a transaction, are subject to inventory risk, have latitude in establishing prices and selecting suppliers, or have several but not all of these indicators, revenue is recorded gross. If we are not the primary obligor in the transaction and amounts earned are determined using a fixed percentage, revenue is recorded on a net basis. Currently, the majority of both direct revenue and fulfillment partner revenue is recorded on a gross basis, as we are the primary obligor. In our statements of operations, we present revenue net of sales taxes.
We periodically provide incentive offers to our customers to encourage purchases. Such offers include current discount offers, such as percentage discounts off current purchases and other similar offers, which, when used by our customers, are treated as a reduction of revenue.
Direct revenue
Direct revenue is derived from merchandise sales to individual consumers and businesses that are fulfilled from our leased warehouses. Direct revenue comes from sales that occur primarily through our Website, but may also occur through offline channels. Fulfillment partner revenue Fulfillment partner revenue is derived from merchandise sales through our Website which fulfillment partners ship directly to consumers and businesses from warehouses maintained by our fulfillment partners. We operate an online site for listing cars for sale as a part of our Website. The cars listing service allows dealers to list vehicles for sale and allows buyers to review vehicle descriptions, post offers to purchase, and provides the means for purchasers to contact sellers for further information and negotiations on the purchase of an advertised vehicle. Revenue from the cars listing business is included in the fulfillment partner segment on a net basis. We offer a consignment service to suppliers where the suppliers' merchandise is stored in and shipped from our leased warehouses. We pay the consignment supplier upon sale of the consigned merchandise to the consumer. Revenue from consignment service to suppliers is included in fulfillment partner segment on a gross basis.
In
InJuly 2011 , we began an insurance shopping service as part of our Website where customers can shop for auto and home insurance and compare quotes from various insurance providers. We also earn advertisement revenue from our insurance business. Revenue generated from our insurance shopping site is included in the fulfillment partner segment on a net basis. 48
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Prior toJuly 2011 , we operated an online auction service on our Website. InJuly 2011 , we removed our Marketplace tab from our Website and no longer provide auction services. The financial results and related assets of the online auction service were not significant to our business. The Marketplace tab allowed sellers to list items for sale, buyers to bid on items of interest, and users to browse through listed items online. Except in limited circumstances where our auction site listed returned merchandise, we were not the seller of auction-listed items and had no control over the pricing of those items. Therefore, the listing fees for items sold at auction by sellers were recorded as revenue during the period these items were listed or sold on a net basis. The revenue for the returned merchandise that we sold at auction was recorded on a gross basis. Revenue from the auctions business is included in the fulfillment partner segment. Prior toJune 2011 , we operated an online site for listing real estate for sale as a part of our Website. InJune 2011 , we removed our online site for listing real estate for sale from our Website and no longer provide these real estate listing services. The financial results and related assets of the online site for real estate for sale were not significant to our business. The real estate listing service allowed customers to search active listings across the country. Revenue from the real estate listing business is included in the fulfillment partner segment, on a net basis. Prior toJune 2011 , we operated Eziba.com, a private sale website featuring home décor products, jewelry, apparel and accessories from many leading brands. InJune 2011 , we turned off the Eziba.com website; however, we continue to sell the type of products that were listed on Eziba.com through our websites, O.co andOverstock.com .
Revenue from our other businesses is less than 1% of total net revenues.
International business
We began selling products through our Website to customers outsidethe United States in lateAugust 2008 . As ofDecember 31, 2011 , we were offering products to customers in over 105 countries and non-U.S. territories. We do not have sales operations outsidethe United States , and are using a U.S. based third party to provide logistics and fulfillment for all international orders. Revenue generated from our international business is included in either direct or fulfillment partner revenue, depending on whether the product is shipped from our warehouses or from a fulfillment partner. Less than 1% of our sales are made to international customers. Club O loyalty program We have a customer loyalty program called Club O for which we sell annual memberships. We record membership fees as deferred revenue and we recognize revenue ratably over the membership period. The Club O loyalty program allows members to earn reward dollars for qualifying purchases made on our Website. We also have a co-branded credit card program (see "Co-branded credit card revenue" below for more information). Co-branded cardholders are also Club O members and earn additional reward dollars for purchases made on our Website, and from other merchants. Reward dollars earned may be redeemed on future purchases made through our Website. Club O reward dollars expire 90 days after the customer's Club O membership expires. We account for these transactions as multiple element arrangements and allocate value to the elements using their relative fair values. We include the value of reward dollars earned in deferred revenue and we record it as a reduction of revenue at the time the reward dollars are earned. We recognize revenue for Club O reward dollars when: (i) customers redeem their reward dollars as part of a purchase at our Website, (ii) reward dollars expire or (iii) the likelihood of reward dollars being redeemed by a customer is remote ("reward dollar breakage"). Due to the loyalty program's short history, currently no reward dollar breakage is recognized until the reward dollars expire. However, in the future we plan to recognize such breakage based upon historical redemption patterns. 49
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In instances where customers receive free Club O reward dollars not associated with any purchases, we account for these transactions as sales incentives such as coupons and record a reduction of revenue at the time the reward dollars are redeemed.
Co-branded credit card revenue
During the year endedDecember 31, 2009 , we had a co-branded credit card agreement with a commercial bank, for the issuance of credit cards bearing the Overstock brand, under which the bank paid us fees for new accounts, renewed accounts and card usage. New and renewed account fees were recognized as revenues on a straight-line basis over the estimated life of the credit card relationship. Credit card usage fees were recognized as revenues as actual credit card usage occurred. Our co-branded credit card agreement with this bank terminated effectiveAugust 30, 2009 . InMarch 2010 , we entered into a co-branded credit card agreement with a different commercial bank for the issuance of credit cards bearing the Overstock.com brand, under which the bank pays us fees for new accounts and for customer usage of the cards. The agreement also provides for a customer loyalty program offering reward points that customers will accrue from card usage and can use to make purchases on our Website (See "Club O loyalty program" above for more information). We launched this co-branded card inSeptember 2010 . New account fees are recognized as revenue on a straight-line basis over the estimated life of the credit card relationship. Credit card usage fees are recognized as revenues as actual credit card usage occurs.
Deferred revenue
Customer orders are recorded as deferred revenue prior to delivery of products or services ordered. We record amounts received for Club O membership fees as deferred revenue and we recognize it ratably over the membership period. We record Club O reward dollars earned from purchases as deferred revenue at the time they are earned and we recognize it as revenue upon redemption. If reward dollars are not redeemed, we recognize revenue upon expiration. In addition, we sell gift cards and record related deferred revenue at the time of the sale. We sell gift cards without expiration dates and we recognize revenue from a gift card upon redemption of the gift card. If a gift card is not redeemed, we recognize income when the likelihood of its redemption becomes remote based on our historical redemption experience. We consider the likelihood of redemption to be remote after 36 months.
Sales returns allowance
We inspect returned items when they arrive at our processing facility. We refund the full cost of the merchandise returned and all original shipping charges if the returned item is defective or we or our fulfillment partners have made an error, such as shipping the wrong product. If the return is not a result of a product defect or a fulfillment error and the customer initiates a return of an unopened item within 30 days of delivery, for most products we refund the full cost of the merchandise minus the original shipping charge and actual return shipping fees. However, we reduce refunds for returns initiated more than 30 days after delivery or that are received at our returns processing facility more than 45 days after initial delivery. If our customer returns an item that has been opened or shows signs of wear, we issue a partial refund minus the original shipping charge and actual return shipping fees. Revenue is recorded net of estimated returns. We record an allowance for returns based on current period revenues and historical returns experience. We analyze actual historical returns, current economic trends and changes in order volume and acceptance of our products when evaluating the adequacy of the sales returns allowance in any accounting period. 50
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During the three months endedDecember 31, 2009 , we had a change in estimate for our sales returns allowance that reduced the allowance by approximately$3.0 million from the prior quarter-end balance and$3.2 million from the prior year-end balance that was recorded in accordance with ASC 250 "Accounting Changes and Error Corrections" on a prospective basis. The change in estimate for our sales returns allowance had the following impact on our financial results for the three and twelve months endedDecember 31, 2009 (amounts in thousands, except per share data): Three months Twelve months ended ended December 31, December 31, 2009 2009 ($ Change) ($ Change) Revenue, net $ 2,995 $ 3,208 Gross profit 752 805 Income from continuing operations before income taxes 752
805
Net income 752
805
Net income attributable to common shares-basic $ 0.04 $
0.04
Net income attributable to common shares-diluted $ 0.04 $
0.03
The reasons for the change in estimate in the fourth quarter of 2009 were as follows. We made improvements to our information systems during 2008 and 2009 that enabled enhanced reporting and analysis of our returns data used in the estimation process. In early 2009, we implemented initiatives to reduce overall return rates in several of our product categories. InSeptember 2009 , we entered into a new master supplier agreement with our fulfillment partners that provided financial incentives for suppliers to reduce returns. These initiatives resulted in a sustained decrease in our product return trends resulting in the change in estimate of sales returns allowance during the three months endedDecember 31, 2009 . Although we believe that our estimates, assumptions, and judgments are reasonable, actual results have historically differed from our estimates. Based on our actual returns experience throughDecember 31, 2011 , had our estimated returns equaled our actual returns, our net loss would have decreased approximately$1.5 million for the year endedDecember 31, 2007 , our net loss would have increased approximately$725,000 for the year endedDecember 31, 2008 , and our net income would have decreased approximately$805,000 for the year endedDecember 31, 2009 . Based on the improvements and initiatives discussed above, we believe that our estimates, assumptions and judgments have improved and our actual product returns have not differed materially from our estimates atDecember 31, 2010 and during 2011.
The allowance for returns was
Credit card chargeback allowance
Revenue is recorded net of estimated credit card chargebacks. We maintain an allowance for credit card chargebacks based on current period revenues and historical chargeback experience. The allowance for chargebacks was$187,000 and$125,000 atDecember 31, 2011 and 2010, respectively.
Allowance for doubtful accounts
From time to time, we grant credit to certain of our business customers on normal credit terms (typically 30 days). We perform credit evaluations of our business customers' financial condition and payment history and maintain an allowance for doubtful accounts receivable based upon our historical collection experience and expected collectability of accounts receivable. The allowance for doubtful accounts receivable was$574,000 and$2.0 million atDecember 31, 2011 andDecember 31, 2010 , respectively. The decrease in the allowance for doubtful accounts was primarily due to write-offs of 51
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accounts receivable during the year ended
Valuation of inventories
We write down our inventory for estimated obsolescence and to lower of cost or 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 allowance represents the new cost basis of such products.
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 Website and processes supporting our business. We capitalize costs incurred during the application development stage of internal-use software and amortize these costs over the estimated useful life of two to three years. Costs incurred related to design or maintenance of internal-use software are expensed as incurred.
Accounting for income taxes
We are subject to taxation from federal and state jurisdictions. A significant amount of judgment is involved in preparing our annual provision for income taxes and the calculation of resulting deferred tax assets and liabilities. As ofDecember 31, 2011 , we were not under audit byUnited States income taxing authorities. Tax periods within the statutory period of limitations not previously audited are potentially open for examination by the taxing authorities. Potential liabilities associated with these years will be resolved when an event occurs to warrant closure, primarily through the completion of audits by the taxing jurisdictions and/or the expiration of the statutes of limitation. To the extent audits or other events result in a material adjustment to the accrued estimates, the effect would be recognized during the period of the event. We follow the asset and liability method of accounting for income taxes. Under this method, deferred taxes are determined based on the temporary differences between the financial statement and tax bases of assets and liabilities using enacted tax rates expected to be in effect during the years in which the bases differences reverse. A valuation allowance is recorded to reduce deferred tax assets when it is more likely than not that some portion, or all of the deferred tax assets may not be realized. Since inception, we determined that it was more likely than not that our historic and current year income tax benefits may not be realized and a full valuation allowance should be recorded against our deferred tax assets in excess of our deferred tax liabilities. As ofDecember 31, 2011 and 2010, we have recorded a full valuation allowance of$83.6 million and$77.1 million , respectively, against our net deferred tax assets consisting primarily of net operating loss carryforwards. In assessing the realizability of our deferred tax assets, we considered the four sources of taxable income. Because we have no carryback ability and have not identified any viable tax planning strategies, two of the sources are not available. Reversing taxable temporary differences have been properly considered as the deferred tax liabilities reverse in the same period as existing deferred tax assets. However, reversing the deferred tax liabilities is insufficient to fully recover existing deferred tax assets. Our valuation allowance is net of deferred tax liabilities and there are no deferred tax assets or liabilities that have an indefinite reversal period. Therefore, future taxable income, the most subjective of the four sources, is the remaining source available for realization of our net deferred tax assets. We consider future taxable income and evaluate the need for a valuation allowance on a regular basis. The determination of recording or releasing tax valuation allowances is made, in part, pursuant to an assessment regarding the likelihood that we will generate future taxable income against which 52
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benefits of our deferred tax assets may be realized. This assessment requires us to exercise significant judgment and make estimates with respect to our ability to generate revenues, gross profits, operating income and taxable income in future periods. Among other factors, we must make assumptions regarding overall business and retail industry conditions, operating efficiencies, the competitive environment and changes in regulatory requirements which may impact our ability to generate taxable income and, in turn, realize the value of our deferred tax assets. Operating losses in some prior periods and significant economic uncertainties in the market have made the projection of future taxable income uncertain. Accordingly, we have a valuation allowance recorded against our deferred tax assets as it is not "more likely than not" that the assets will be realized. A change in our assessment of the likelihood that we will generate future taxable income may result in a full or partial release of the valuation allowance against our deferred tax assets in future periods.
Impairment of long-lived assets
We review property and equipment and other long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset group may not be recoverable. Recoverability is measured by comparison of the assets' carrying amount to future undiscounted net cash flows the asset group is expected to generate. Cash flow forecasts are based on trends of historical performance and management's estimate of future performance, giving consideration to existing and anticipated competitive and economic conditions. If such asset group is considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the assets exceeds their fair values. There were no impairments to long-lived assets recorded during the years endedDecember 31, 2011 , 2010, and 2009.
Valuation of goodwill
Goodwill is not amortized, but must be tested for impairment at least annually. We test for impairment of goodwill in the fourth quarter or when we deem that a triggering event has occurred. Goodwill totaled
Loss contingencies
In the normal course of business, we are involved in legal proceedings and other potential loss contingencies. We accrue a liability for such matters when it is probable that a loss has been incurred and the amount can be reasonably estimated. When only a range of possible loss can be estimated, the most probable amount in the range is accrued. If no amount within this range is a better estimate than any other amount within the range, the minimum amount in the range is accrued. We expense legal fees as incurred.
Accounting pronouncements issued not yet adopted
See Item 15 of Part IV, "Financial Statements"-Note 2-"Accounting Policies" subheading "Accounting Pronouncements Issued Not Yet Adopted."
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Comparison of Years Ended
Executive Commentary
This executive commentary is intended to provide investors with a view of our business through the eyes of our management. As an executive commentary, it necessarily focuses on selected aspects of our business. This executive commentary is intended as a supplement to, but not a substitute for, the more detailed discussion of our business included elsewhere herein. Investors are cautioned to read our entire "Management's Discussion and Analysis of Financial Condition and Results of Operations", as well as our interim and audited financial statements, and the discussion of our business and risk factors and other information included elsewhere or incorporated in this report. This executive commentary includes forward-looking statements, and investors are cautioned to read the "Special Note Regarding Forward-Looking Statements" at the beginning of Item 2, "Management's Discussion and Analysis of Financial Condition and Results of Operations."
The key factors that affected financial results for the year ended
Revenue for 2011 decreased by$35.6 million (3%), compared to 2010. Visits to our website were down 1% and new customer growth fell 9% which was partially offset by a slightly higher average order size. We believe our revenues were adversely impacted during the first and second quarters when Google Inc. notified us that it was penalizing us in natural search results for noncompliance with some of Google's natural search guidelines. During this penalty period, we dropped significantly in some Google natural search result rankings. We made changes to conform to Google's guidelines and, onApril 21, 2011 , Google ended its penalization of our natural search results. We were able to offset some of the negative impact to revenue by increasing expenditures in other marketing channels. Revenues were hurt by a shift of marketing resources into our Club O loyalty program and away from coupons and other site-wide promotions, which were less effective in generating revenues during the second and third quarter of 2011. We also believe that our efforts to rebrand ourselves fromOverstock.com to O.co hurt revenue growth in 2011 as it confused some prospective customers who had trouble finding our website. Revenues declined by 22% in our direct business due primarily to a transition of some of our clothing and shoes category to a fulfillment partner model. Revenue from our fulfillment partner business increased by 1%. The direct business declined to 16% of total revenue in 2011 from 19% in 2010, while our fulfillment partner business generated 84% of our total revenue in 2011 compared to 81% in 2010. Gross profit declined by 6% while gross margin declined by 40 basis points from 2010 to 2011. Direct gross margin declined by 220 basis points due largely to fixed costs increasing as a percentage of revenue due to declining direct revenues, higher inbound and outbound freight and higher product costs of returned goods due to a sales mix shift to the home and garden category. Fulfillment partner gross margin declined by 50 basis points, largely due to competitive pricing initiatives. Sales and marketing expenses as a percentage of revenue increased by 30 basis points in 2011. This was largely due to an increase in online search marketing throughout the year. We increased our online search marketing in the first and second quarter of 2011 to help offset the lower natural search revenue following the Google penalty, and online marketing spending increased in the second half of the year to compensate for lower revenues as a result of the customer confusion from our O.co rebranding campaign.
Operating expense outpaced gross profit and Contribution (see "Non-GAAP Financial Measures" below for a reconciliation of Contribution to Gross Profit) in 2011. Contribution declined by 9% due to
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lower gross profit and higher sales and marketing expenses, while combined technology and general and administrative expenses increased by 18% driven by increases in technology-related personnel growth, depreciation expense and higher legal fees. As a result, we incurred a net loss of
We completed the redemption of our Senior Notes on
On
We ended the year with
We experienced a$21.1 million year over year increase in free cash flow (See "Non-GAAP Financial Measures" below for a reconciliation of Free Cash Flow to net cash provided by operating activities), from($4.2) million in 2010 to$16.9 million in 2011. This was due primarily to a$9.3 million improvement in operating cash flows and an$11.8 million reduction in capital expenditures in 2011. In earlyJanuary 2012 , we reduced technology and general and administrative staff and contract labor positions, which will reduce annual compensation costs by approximately$8.5 million .
The balance of our Management's Discussion and Analysis of Financial Condition and Results of Operations provides further information about the matters discussed above and other important matters affecting our business.
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Results of Operations
The following table sets forth our results of operations expressed as a percentage of total revenue for 2011, 2010 and 2009:
Year ended December 31 2011 2010 2009 (as a percentage of total revenue) Revenue, net Direct 15.5 % 19.2 % 17.2 % Fulfillment partner 84.5 80.8 82.8 Total net revenue 100.0 100.0 100.0 Cost of goods sold Direct 14.2 17.2 14.9 Fulfillment partner 68.8 65.4 66.3 Total cost of goods sold 83.0 82.6 81.2 Gross profit 17.0 17.4 18.8 Operating expenses: Sales and marketing 5.9 5.6 6.3 Technology 6.4 5.3 6.0 General and administrative 6.4 5.1
5.6
Restructuring - (0.1 )
-
Total operating expenses 18.7 16.0
17.9
Operating income (loss) (1.7 ) 1.4 0.9 Interest income - - - Interest expense (0.2 ) (0.3 ) (0.4 ) Other income, net - 0.2 0.4 Income (loss) before income taxes (1.9 ) 1.3
0.9
Provision (benefit) for income taxes - - - Net income (loss) (1.9 )% 1.3 % 0.9 % Revenue
The following table reflects our net revenue for the years ended
Year ended December 31, 2011 2010 $ Change % Change Revenue, net Direct $ 163,609 $ 209,646 $ (46,037 ) (22.0 )%
Fulfillment partner 890,668 880,227 10,441
1.2 %
Total revenue, net
(3.3 )%
Revenues declined by 22% in our direct business due primarily to a transition of some of our clothing and shoes category to a fulfillment partner model to reduce seasonal inventory risks. Revenue from our fulfillment partner business increased by 1%. The direct business declined to 16% of total revenue in 2011 from 19% in 2010, while our fulfillment partner business generated 84% of our total revenue in 2011 compared to 81% in 2010. 56
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The decrease in net revenue for the year ended
We believe our revenues were negatively impacted during the first and second quarters of 2011 when Google Inc. notified us that it was penalizing us in natural search results for noncompliance with some of Google's natural search guidelines. During this penalty period, we dropped significantly in some of Google's natural search result rankings. We made changes to conform to Google's guidelines and onApril 21, 2011 Google ended its penalization of our natural search results. We were able to offset some of the negative impact to revenue by increasing expenditures in other marketing channels. Revenues were also hurt by a shift of marketing resources into our Club O loyalty program and away from coupons and other site-wide promotions, which were less effective in generating revenues during the second and third quarter of 2011. We also believe that our efforts to rebrand ourselves fromOverstock.com to O.co hurt revenue growth in 2011 as it confused some prospective customers who had trouble finding our website. Total revenues from the Auctions, Cars, Insurance, Travel and Real Estate businesses were$1.7 million and$2.9 million for the years endedDecember 31, 2011 and 2010, respectively. Total revenues from International sales were$8.8 million and$9.4 million for the years endedDecember 31, 2011 and 2010, respectively.
See "Executive Commentary" above for additional discussion regarding revenue.
Gross profit
Our overall gross margins fluctuate based on our sales volume mix between our direct business and fulfillment partner business; changes in vendor and / or customer pricing, including competitive pricing; inventory management decisions within the direct business; sales coupons and promotions; product mix of sales; and operational and fulfillment costs.
The following table reflects our net revenues, cost of goods sold and gross profit for the year ended
Year ended December 31, 2011 2010 $ Change % Change Revenue, net Direct $ 163,609 $ 209,646 $ (46,037 ) (22.0 )% Fulfillment partner 890,668 880,227 10,441 1.2 % Total net revenues $ 1,054,277 $ 1,089,873 $ (35,596 ) (3.3 )% Cost of goods sold Direct $ 149,660 $ 187,124 $ (37,464 ) (20.0 )% Fulfillment partner 725,529 713,109 12,420 1.7 % Total cost of goods sold $ 875,189 $ 900,233 $ (25,044 ) (2.8 )% Gross Profit Direct $ 13,949 $ 22,522 $ (8,573 ) (38.1 )% Fulfillment partner 165,139 167,118 (1,979 ) (1.2 )% Total gross profit $ 179,088 $ 189,640 $ (10,552 ) (5.6 )% 57
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Gross margins for the past eight quarterly periods and years ending
Q1 2011 Q2 2011 Q3 2011 Q4 2011 FY 2011 Direct 10.7 % 9.6 % 6.6 % 7.0 % 8.5 % Fulfillment Partner 20.7 % 18.1 % 17.6 % 17.8 % 18.5 % Combined 18.9 % 16.9 % 16.0 % 16.2 % 17.0 % Q1 2010 Q2 2010 Q3 2010 Q4 2010 FY 2010 Direct 13.8 % 11.7 % 9.1 % 9.0 % 10.7 % Fulfillment Partner 18.8 % 19.4 % 18.7 % 19.0 % 19.0 % Combined 17.9 % 18.0 % 16.9 % 17.0 % 17.4 % The decrease in direct gross margin for the year endedDecember 31, 2011 is primarily due to fixed costs increasing as a percentage of revenue due to declining direct sales, higher inbound and outbound freight and higher product costs from returned goods due to a sales mix shift to the home and garden category.
The decrease in fulfillment partner gross margin for the year ended
The shift of business between direct to fulfillment partner (or vice versa) is an economic decision based on the economics of each particular product offering at the time and we do not have particular goals for "appropriate" mix or percentages for the size of either. We believe that the mix of the business between direct and fulfillment partner is consistent with our strategic objectives for our business model in the current economic environment and, with the exception of a transition of some of our direct clothing and shoes category to a fulfillment partner model to reduce our seasonal inventory risks, we do not currently foresee any material shifts in mix. During reviews of our partner billing system for returns, we discovered that we had underbilled our fulfillment partners for certain fees and charges related to returns of approximately$157,000 and$822,000 for the years endedDecember 31, 2011 and 2010, respectively. Since our business model is reliant on our relationships with our fulfillment partners and the problem related to an internal record keeping issue on our part, we made the determination to not seek recovery of these amounts from our fulfillment partners and consequently have not recognized any related recoveries in our consolidated financial statements.
The other factors described above, such as operational and fulfillment costs did not have a significant impact on the change in gross margin.
Cost of goods sold includes stock-based compensation expense of
See "Executive Commentary" above for additional discussion.
Fulfillment costs
Fulfillment costs include all warehousing costs, including fixed overhead and variable handling costs (excluding packaging costs), as well as credit card fees and customer service costs, all of which we include as costs in calculating gross margin. 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 margin. As a result, our gross margin may not be directly comparable to others in our industry. 58
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The following table has been included to provide investors additional information regarding our classification of fulfillment costs, gross profit and margin, thus enabling investors to better compare our gross margin with others in our industry (in thousands): Year ended December 31, 2011 2010 2009 Total net revenue $ 1,054,277 100 % $ 1,089,873 100 % $ 876,769 100 % Cost of goods sold Product costs and other cost of goods sold 821,739 78 % 842,064 78 % 664,537 76 % Fulfillment and related costs 53,450 5 % 58,169 5 % 47,480 5 % Total cost of goods sold 875,189 83 % 900,233 83 % 712,017 81 % Gross profit $ 179,088 17 % $ 189,640 17 % $ 164,752 19 % Fulfillment costs as a percentage of sales may vary due to several factors, such as our ability to manage costs at our warehouses, significant changes in the number of units received and fulfilled, the extent to which we use third party fulfillment services and warehouses, and our ability to effectively manage customer service costs and credit card fees. There have been no significant changes in our fulfillment and related costs as a percentage of revenue during the year endedDecember 31, 2011 .
Operating expenses
Sales and marketing expenses
We advertise through a number of targeted online marketing channels, such as sponsored search, affiliate marketing, portal advertising, e-mail campaigns, and other initiatives. We also use nationwide television, print and radio advertising campaigns to promote sales.
The following table reflects our sales and marketing expenses for the years ended
Year ended December 31, 2011 2010 $ Change % Change Sales and marketing expenses $ 61,813 $ 61,334 $ 479 0.8 % Sales and marketing expenses as a percent of net revenues 5.9 % 5.6 % The increase in sales and marketing expenses as a percentage of net revenues is primarily due to increased spending in search marketing, increased in part to offset the negative impact of the Google penalty on revenues as described above, partially offset by a decline in spending for affiliate marketing and television advertising.
Sales and marketing expenses include stock-based compensation expense of
Costs associated with our discounted shipping and other promotions, such as coupons, are not included in marketing expense. Rather they are accounted for as a reduction of revenue and therefore affect sales and gross margin. We consider discounted shipping and other promotions as an effective marketing tool, and intend to continue to offer them as we deem appropriate as part of our overall marketing plan. 59
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Technology expenses
We seek to efficiently invest in technology, including web services, customer support solutions and website search, and in expansion of new and existing product categories, and in investments in technology to enhance the customer experience, improve our process efficiency and support our logistics infrastructure.
The following table reflects our technology expenses for the years ended
Year ended December 31, 2011 2010 $ Change % Change Technology expenses $ 67,043 $ 58,260 $ 8,783 15.1 % Technology expenses as a percent of net revenues 6.4 % 5.3 %
The increase for the year ended
Technology expenses include stock-based compensation expense of
General and administrative expenses
The following table reflects our general and administrative expenses for the years ended
Year ended December 31, 2011 2010 $ Change % Change General and administrative expenses $ 67,766 $ 55,650 $ 12,116 21.8 % General and administrative expenses as a percent of net revenues 6.4 % 5.1 %
The increase in general and administrative expenses for the year ended
General and administrative expenses include stock-based compensation expense of approximately$1.9 million and$3.2 million for the years endedDecember 31, 2011 and 2010, respectively.
Restructuring
There were no restructuring charges or reversals during the year endedDecember 31, 2011 . We reversed$569,000 of lease termination costs liability during the year endedDecember 31, 2010 due to changes in our estimate of sublease income, primarily as a result of our entering into agreements with a sublessee to terminate the subleases and have us re-occupy a portion of the space previously abandoned (see Item 15 of Part IV, "Financial Statements"-Note 3-"Restructuring Expense").
Operating Expenses
Overall, our total operating expenses increased 12.6% to
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Table of Contents Depreciation expense Depreciation expense is classified within the corresponding operating expense categories on the consolidated statements of operations as follows (in thousands): Year ended December 31, 2011 2010 2009 Cost of goods sold-direct $ 714 $ 1,179 $ 1,264 Technology 14,433 12,489 10,943 General and administrative 1,203 912 676 Total depreciation and amortization, including internal-use software and website development $ 16,350 $
14,580
Non-operating income (expense)
Interest income
Interest income is primarily derived from the investment of our cash in cash equivalents and short-term investments. Interest income for the years ended
Interest expense
Interest expense is related to interest incurred on our Senior Notes, finance obligations, line of credit and our capital leases. Interest expense for the year endedDecember 31, 2011 and 2010 totaled$2.5 million and$3.0 million , respectively. The decrease in interest expense is primarily a result of extinguishments of our Senior Notes, partially offset by an increase from our finance obligations and line of credit.
Other income, net
Other income, net for the years endedDecember 31, 2011 and 2010 totaled$278,000 and$2.1 million , respectively. The decrease was primarily due to a$1.2 million loss on early retirement of our finance obligations resulting from a prepayment premium in 2011 and a$346,000 decrease due to gains on Senior Notes buybacks in 2010.
Income taxes
Our provision (benefit) for income taxes for the years endedDecember 31, 2011 and 2010 of($142,000) and$359,000 is for federal alternative minimum tax and certain income tax uncertainties, including interest and penalties. As ofDecember 31, 2011 andDecember 31, 2010 we had federal net operating loss carry forwards of approximately$192.5 and$166.7 million , respectively, and state net operating loss carry forwards of approximately$176.1 and$150.7 million , respectively, which may be used to offset future taxable income. We are currently reviewing whether we had any ownership changes. The result of having ownership changes under Internal Revenue Code Section 382 would limit the amount of net operating losses that could be used in any annual period. Our net operating loss carryforwards will begin to expire in 2018.
Seasonality
Based upon our historical experience, revenue typically increases during the fourth quarter because of the holiday 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
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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 total net revenues for each of the quarters in 2011 and 2010 (in thousands): First Second Third Fourth Quarter Quarter Quarter Quarter 2011 $ 265,470 $ 234,992 $ 239,738 $ 314,077 2010 264,330 $ 231,253 $ 245,420 $ 348,870
Comparison of Years Ended
Executive Commentary
This executive commentary is intended to provide investors with a view of our business through the eyes of our management. As an executive commentary, it necessarily focuses on selected aspects of our business. This executive commentary is intended as a supplement to, but not a substitute for, the more detailed discussion of our business included elsewhere herein, Investors are cautioned to read our entire "Management's Discussion and Analysis of Financial Condition and Results of Operations", as well as our interim and audited financial statements, and the discussion of our business and risk factors and other information included elsewhere or incorporated in this report. This executive commentary includes forward-looking statements, and investors are cautioned to read the "Special Note Regarding Forward-Looking Statements" at the beginning of Item 2, "Management's Discussion and Analysis of Financial Condition and Results of Operations."
The key factors that affected financial results for the year ended
Revenues in 2010 increased by 24% compared to 2009. Our pricing and marketing initiatives drove improvement in several key components of revenue growth, including new customer growth, visits to our Website, conversion and average order size. Growth was broadly distributed across most of our major product categories, and in both our direct and fulfillment partner business. Our direct business increased by 39%, and our fulfillment partner business increased by 21%. The direct business was 19% of total revenue in 2010 compared to 17% in 2009, while our fulfillment partner business generated 81% of our total revenue compared to 83% in 2009. Revenue growth slowed over 2010 from 42% in Q1 to 8% in Q4. While this is partly explained by an increasing revenue growth pattern in 2009, we also experienced softness during the holiday selling season that we believe was due in part to our decision to focus on contribution growth rather than revenue growth, (see discussion of the non-GAAP financial measure "contribution" below), particularly by not heavily promoting our BMMG and consumer electronics categories, both of which are popular holiday categories that typically have lower gross margin. Gross margin fell by 140 basis points in 2010, although gross profit growth in 2010 was 15% compared to 14% in 2009. While we believe that pricing initiatives had a positive effect on our revenue growth, they had the opposite effect on gross margin. This was offset somewhat by supply chain efficiencies resulting from initiatives focused on returns and fulfillment, and from a favorable sales mix shift this year away from BMMG and consumer electronics into home and garden products. Sales and marketing expense as a percentage of revenue in 2010 fell 70 basis points to 5.6%. We believe that we used relatively effective advertising campaigns and maintained a disciplined approach to marketing expenditures, and that our pricing and other promotional activities were also effective in generating revenues. We believe that our primary focus of increasing contribution has been an important factor in improving our marketing efficiency. 62
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Although we made significant investments in 2010 through increases in IT, marketing and merchandising related personnel and through increased capital expenditures, technology and G&A expenses increased at a slower rate than contribution. Contribution growth was 17% in 2010, while combined technology and G&A expenses increased by 13%.
Net income improved by
We retired$25.4 million face amount of our Senior Notes throughout the year, using$24.9 million of cash. As ofDecember 31, 2010 ,$34.6 million face amount of the Senior Notes remained outstanding and are a current liability at year-end. As a result, working capital decreased to$14.7 million at year-end. We experienced a$43.0 million year over year decrease in free cash flow (See "Non-GAAP Financial Measures" below for a reconciliation of Free Cash Flow to net cash provided by operating activities), from$38.8 million in 2009 to($4.2) million in 2010. This was due primarily to$13.2 million of incremental capital expenditures in 2010 over 2009 and a$29.8 million decrease in operating cash flow due primarily to changes and timing differences in inventory, accounts payable and accrued liabilities that were partially offset by changes in net income, depreciation and amortization, and gains on the early retirement of our Senior Notes.
The balance of our Management's Discussion and Analysis of Financial Condition and Results of Operations provides further information about the matters discussed above and other important matters affecting our business.
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Results of Operations
The following table sets forth our results of operations expressed as a percentage of total revenue for 2010 and 2009:
Year ended December 31 2010 2009 Revenue, net Direct 19.2 % 17.2 % Fulfillment partner 80.8 82.8 Total net revenue 100.0 100.0 Cost of goods sold Direct 17.2 14.9 Fulfillment partner 65.4 66.3 Total cost of goods sold 82.6 81.2 Gross profit 17.4 18.8 Operating expenses: Sales and marketing 5.6 6.3 Technology 5.3 6.0 General and administrative 5.1 5.6 Restructuring (0.1 ) - Total operating expenses 16.0 17.9 Operating income (loss) 1.4 0.9 Interest income - - Interest expense (0.3 ) (0.4 ) Other income (expense), net 0.2 0.4 Net income (loss) before income taxes 1.3 0.9 Provision for income taxes - - Net income (loss) 1.3 % 0.9 % Revenue
The following table reflects our net revenue for the years ended
Year ended December 31, 2010 2009 $ Change % Change Revenue, net Direct $ 209,646 $ 150,901 $ 58,745 38.9 % Fulfillment partner 880,227 725,868 154,359 21.3 % Total revenue, net $ 1,089,873 $ 876,769 $ 213,104 24.3 %
Total net revenue increased 24% to
Direct revenue increased 39% to
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Total net revenue increased 8% to$349 million for the three months endedDecember 31, 2010 , from$322 million for the three months endedDecember 31, 2009 . Direct revenue increased 26% to$69.2 million for the three months endedDecember 31, 2010 , from$55.1 million for the three months endedDecember 31, 2009 . Fulfillment partner revenue increased 5% to$280 million for the three months endedDecember 31, 2010 , from$267 million for the three months endedDecember 31, 2009 .
Total revenues from Auctions, Cars and Real Estate businesses were
See "Executive Commentary" above for additional discussion regarding revenue and revenue growth.
Gross profit Our overall gross margins fluctuate based on our sales volume mix between our direct business and fulfillment partner business; changes in vendor and / or customer pricing, including competitive pricing, and inventory management decisions within the direct business; sales coupons and promotions; product mix of sales; and operational and fulfillment costs.
The following table reflects our net revenues, cost of goods sold and gross profit for the year ended
Year ended December 31, 2010 2009 $ Change % Change Revenue, net Direct $ 209,646 $ 150,901 $ 58,745 38.9 % Fulfillment partner 880,227 725,868 154,359 21.3 % Total net revenues $ 1,089,873 $ 876,769 $ 213,104 24.3 % Cost of goods sold Direct $ 187,124 $ 130,890 $ 56,234 43.0 % Fulfillment partner 713,109 581,127 131,982 22.7 % Total cost of goods sold $ 900,233 $ 712,017 $ 188,216 26.4 % Gross Profit Direct $ 22,522 $ 20,011 $ 2,511 12.5 % Fulfillment partner 167,118 144,741 22,377 15.5 % Total gross profit $ 189,640 $ 164,752 $ 24,888 15.1 %
Gross margins for the past eight quarterly periods and years ending
Q1 2010 Q2 2010 Q3 2010 Q4 2010 FY 2010 Direct 13.8 % 11.7 % 9.1 % 9.0 % 10.7 % Fulfillment Partner 18.8 % 19.4 % 18.7 % 19.0 % 19.0 % Combined 17.9 % 18.0 % 16.9 % 17.0 % 17.4 % Q1 2009 Q2 2009 Q3 2009 Q4 2009 FY 2009 Direct 12.9 % 18.0 % 11.8 % 11.9 % 13.3 % Fulfillment Partner 21.0 % 21.3 % 20.7 % 18.1 % 19.9 % Combined 19.5 % 20.7 % 19.3 % 17.1 % 18.8 % 65
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Direct Gross Profit and Gross Margin-Gross profit for our direct business increased 12.5% to$22.5 million for the year endedDecember 31, 2010 , from$20.0 million for 2009. Gross margin for the direct business decreased to 10.7% for the year endedDecember 31, 2010 , from 13.3% 2009. The decrease in gross margin for the year endedDecember 31, 2010 is primarily due to pricing initiatives that were implemented beginning in the third quarter of 2009 and an increase in returns related costs, partially offset by leverage gained on fixed warehousing costs due to increased revenues. Gross profit for our direct business was essentially unchanged at$6.3 million for the three monthsDecember 31, 2010 , and$6.6 million for the same period in 2009. Gross margin for the direct business decreased to 9.0% for the three months endedDecember 31, 2010 , from 11.9% for the same period in 2009. The decrease in gross margin for three months endedDecember 31, 2010 is primarily due to pricing initiatives including holiday promotions and mark-downs of slow-moving inventory (primarily on apparel and shoes), partially offset by a shift in sales mix to higher margin products along with leverage gained on fixed warehousing costs due to increased revenues. Fulfillment Partner Gross Profit and Gross Margin-Gross profit for our fulfillment partner business increased 15.5% to$167.1 million for the year endedDecember 31, 2010 , from$144.7 million for 2009. Gross margin for the fulfillment partner business decreased to 19.0% for the year endedDecember 31, 2010 , from 19.9% for 2009. The decrease in gross margin for the year endedDecember 31, 2010 is primarily due to pricing initiatives that were implemented beginning in the third quarter of 2009, partially offset by a shift in sales mix to higher margin products as well as lower returns-related costs. Gross profit for our fulfillment partner business increased 9.7% to$53.2 million for the three months endedDecember 31, 2010 , compared to$48.5 million for the same period in 2009. Gross margin for the fulfillment partner business increased to 19.0% for the three months endedDecember 31, 2010 compared to 18.1% for the same period in 2009. The increase in gross margin was primarily due to a reduction in product costs, including reductions from suppliers participating in promotions, along with a shift in sales mix to higher margin products, partially offset by pricing initiatives. During reviews of our partner billing system for returns, we discovered that we had underbilled our fulfillment partners for certain fees and charges related to returns of approximately$822,000 and$1.6 million for the years endedDecember 31, 2010 and 2009, respectively. Since our business model is reliant on our relationships with our fulfillment partners and the problem related to an internal record keeping issue on our part, we have made the determination to not seek recovery of these amounts from our fulfillment partners and consequently have not recognized any related recoveries in our consolidated financial statements.
The other factors described above, did not have a significant effect on the change in gross profit.
Cost of goods sold includes stock-based compensation expense of
See "Executive Commentary" above for additional discussion.
Fulfillment costs
Fulfillment costs include all warehousing costs, including fixed overhead and variable handling costs (excluding packaging costs), as well as credit card fees and customer service costs, all of which we include as costs in calculating gross margin. 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 margin. As a result, our gross margin may not be directly comparable to others in our industry. 66
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The following table has been included to provide investors additional information regarding our classification of fulfillment costs, gross profit and margin, thus enabling investors to better compare our gross margin with others in our industry (in thousands): Year ended December 31, 2010 2009 Total net revenue $ 1,089,873 100 % $ 876,769 100 % Cost of goods sold
Product costs and other cost of goods sold 842,064 78 % 664,537 76 %
Fulfillment and related costs 58,169 5 % 47,480 5 % Total cost of goods sold 900,233 83 % 712,017 81 % Gross profit $ 189,640 17 % $ 164,752 19 % Fulfillment costs as a percentage of sales may vary due to several factors, such as our ability to manage costs at our warehouses, significant changes in the number of units received and fulfilled, the extent to which we use third party fulfillment services and warehouses, and our ability to effectively manage customer service costs and credit card fees. There have been no significant changes in our fulfillment costs during the year endedDecember 31, 2010 .
Operating expenses
Sales and marketing expenses
We advertise through a number of targeted online marketing channels, such as sponsored search, affiliate marketing, portal advertising, e-mail campaigns, and other initiatives. We also use nationwide television, print and radio advertising campaigns to promote sales.
The following table reflects our sales and marketing expenses for the years ended
Year ended December 31, 2010 2009 $ Change % Change Sales and marketing expenses $ 61,334 $ 55,549 $ 5,785 10.4 % Sales and marketing expenses as a percent of net revenues 5.6 % 6.3 %
The decrease in sales and marketing costs as a percentage of total net revenue was primarily due to more efficient marketing spending.
Sales and marketing expenses also include stock-based compensation expense of
Costs associated with our discounted shipping and other promotions, such as coupons, are not included in marketing expense. Rather they are accounted for as a reduction of revenue and therefore affect sales growth and gross margin. We consider discounted shipping and other promotions as an effective marketing tool, and intend to continue to offer them as we deem appropriate as part of our overall marketing plan. 67
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Technology expenses
We seek to efficiently invest in technology, including web services, customer support solutions, website search, and expansion of new and existing product categories, as well as continuing to enhance the customer experience, improving our process efficiency and supporting our logistics infrastructure.
The following table reflects our technology expenses for the years ended
Year ended December 31, 2010 2009 $ Change % Change Technology expenses $ 58,260 $ 52,336 $ 5,924 11.3 % Technology expenses as a percent of net revenues 5.3 % 6.0 % The$5.9 million increase is primarily due to a$6.5 million increase in salaries and benefits expense (primarily due to increases in staffing), and a$1.5 million increase in depreciation expense as result of investments in information technology assets in 2010, partially offset by a$1.4 million decrease in bonus expense in 2010 as a result of lower than expected financial performance for the year endedDecember 31, 2010 .
Technology expenses include stock-based compensation expense of
General and administrative expenses
The following table reflects our general and administrative expenses for the years ended
Year ended December 31, 2010 2009 $ Change % Change General and administrative expenses $ 55,650 $ 48,906 $ 6,744 13.8 % General and administrative expenses as a percent of net revenues 5.1 % 5.6 % The$6.7 million increase is due to a$5.1 million increase in salaries and benefits expense (primarily due to increases in staffing), a$2.3 million increase in professional service fees for our external auditors and a$2.0 million increase in legal fees, partially offset by a$3.2 million decrease in bonus expense in 2010 as a result of lower than expected financial performance for the year endedDecember 31, 2010 . The increase in legal fees primarily resulted from a$2.6 million reduction in payments received from the settlement of legal matters during 2010 compared to 2009. We recognized a reduction in general and administrative expenses of$4.5 million and$7.1 million during the years endedDecember 31, 2010 and 2009, respectively, related to the settlement of legal matters. General and administrative expenses include stock-based compensation expense of approximately$3.2 million and$3.0 million for the years endedDecember 31, 2010 and 2009, respectively.
Restructuring
There were no restructuring charges during the years endedDecember 31, 2010 and 2009. We reversed$569,000 of lease termination costs liability during the year endedDecember 31, 2010 due to changes in our estimate of sublease income, primarily as a result of our entering into agreements with a sublessee to terminate the subleases and have us re-occupy a portion of the space previously 68
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abandoned, due to our growth and need for additional space. During the year ended
Operating Expenses
Overall, our total operating expenses increased 11.5% to$174.7 million for the year endedDecember 31, 2010 from$156.7 million for the year endedDecember 31, 2009 , while total net revenues increased 24.3% and gross profit increased 15.1%. Depreciation expense Depreciation expense is classified within the corresponding operating expense categories on the consolidated statements of operations as follows (in thousands): Year ended December 31, 2010 2009 Cost of goods sold-direct $ 1,179 $ 1,264 Technology 12,489 10,943 General and administrative 912 676
Total depreciation and amortization, including internal-use software and website development
$ 14,580
Non-operating income (expense)
Interest income
Interest income is primarily derived from the investment of our cash in cash equivalents and short-term investments. Interest income for the years ended
Interest expense
Interest expense is related to interest incurred on our Senior Notes, our finance obligations and our capital leases. Interest expense for the year endedDecember 31, 2010 and 2009 totaled$3.0 million and$3.5 million , respectively. The decrease in interest expense is primarily a result of extinguishments of long-term debt. Other income, net Other income, net for the years endedDecember 31, 2010 and 2009 totaled$2.1 million and$3.3 million , respectively. The decrease was primarily due to lower gains on extinguishment of long-term debt, partially offset by an increase in gift card breakage income for the year endedDecember 31, 2010 .
Income taxes
Our provision for income taxes for the years endedDecember 31, 2010 and 2009 of$359,000 and$257,000 is for federal alternative minimum tax and certain income tax uncertainties, including interest and penalties. 69
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Seasonality
Based upon our historical experience, revenue typically increases during the fourth quarter because of the holiday 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 total net revenues for each of the quarters in 2010 and 2009 (in thousands): First Second Third Fourth Quarter Quarter Quarter Quarter 2010 $ 264,330 $ 231,253 $ 245,420 $ 348,870 2009 185,729 174,898 193,783 322,359
Liquidity and Capital Resources
While we believe that the cash and cash equivalents 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. Our$20 million credit facility withU.S. Bank is scheduled to terminate onDecember 31, 2012 . Although we have$20 million on deposit withU.S. Bank , and may repay and terminate the facility, we may attempt to renegotiate the facility or replace it. There can be no assurance we will be able to do so. InDecember 2011 , we paid$20.1 million to terminate our obligations under our Master Lease Agreement, resulting in a significant decrease in cash on hand atDecember 31, 2011 (see "Borrowings" below). 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, profits or to raise additional capital could have a material adverse effect on our operations and on our ability to achieve our intended business objectives. Any projections of future cash needs and cash flows are subject to substantial uncertainty. Our principal sources of liquidity are cash flows generated from operations, and our existing cash and cash equivalents. AtDecember 31, 2011 , our cash and cash equivalents balance was$97.0 million . Cash flow information is as follows: Year ended December 31 2011 2010 2009 Cash provided by (used in): Operating activities $ 25,663 $ 16,322 $ 46,117 Investing activities (8,905 ) (22,700 ) 2,868 Financing activities (43,794 ) (9,358 ) (5,685 ) Free Cash Flow "FreeCash Flow " (a non-GAAP measure) for the years endedDecember 31, 2011 , 2010 and 2009, was$16.9 million ,$(4.2) million and$38.8 million , respectively. See "Non-GAAP Financial Measures" below for a reconciliation of Free Cash Flow to net cash provided by operating activities.
Cash provided by operating activities
For the years ended
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Cash received from customers generally corresponds to our net revenues as our customers primarily use credit cards to buy from us causing our receivables from these sales transactions to settle quickly. We have payment terms with our fulfillment partners that generally extend beyond the amount of time necessary to collect proceeds from our customers. As a result, following our typically seasonally strong fourth quarter sales, atDecember 31 of each year, our cash, cash equivalents and accounts payable balances normally 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 declines during the first three months following year-end, which normally results in a decline in our cash and cash equivalents balances from the year-end balance. The seasonality of our business causes payables and accruals to grow significantly in the fourth quarter, and then decrease in the first quarter when they are paid. The$25.7 million of net cash provided by operating activities during the year endedDecember 31, 2011 was primarily due to a decrease in inventory of$9.1 million from an effort to maintain lower inventory levels and a shift in sales mix, particularly in clothing and shoes, from a direct inventory-based model to a fulfillment partner-based model to reduce seasonal inventory risks, an increases in accrued liabilities of$7.0 million primarily related to marketing and legal expenses, an increase in deferred revenue of$4.0 million primarily due to continued growth of our Club O loyalty program and an increase in accounts payable of$2.9 million . The$16.3 million of net cash provided by operating activities during the year endedDecember 31, 2010 was primarily due to positive net income of$13.9 million for the year endedDecember 31, 2010 . Net cash was also provided by increases of deferred revenue of$3.4 million primarily due to our launch of our Club O loyalty program. The cash inflows were offset by cash outflows of$8.7 million due to an increase in inventory and$9.3 million due to a decrease in accounts payable. The increase in inventory was a result of increased purchases of inventory to meet holiday sales demand and support growth in the business. The decrease in accounts payable balance is due to increased and earlier sales and holiday shipments resulting in increased payments to suppliers prior to year-end when compared to the same period in 2009.
Cash (used in) provided by investing activities
Cash provided by investing activities corresponds with purchases, sales, and maturities of marketable securities and cash expenditures for fixed assets, including internal-use software and website development costs. For the years endedDecember 31, 2011 and 2010, investing activities resulted in net cash outflows of$8.9 million and$22.7 million , respectively.
The
The$22.7 million used in investing activities during the year endedDecember 31, 2010 resulted primarily from expenditures for fixed assets of$20.5 million , which largely consisted of software and hardware purchases for our data warehouse and other data storage infrastructure in order to support our growth, and a$1.7 million investment in precious metals in an effort to diversify our investments.
Cash used in financing activities
For the years ended
Financing activities for the year endedDecember 31, 2011 resulted in net cash outflows of$43.8 million primarily from$34.6 million used for retirement of long-term debt,$24.9 million used for 71
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retirement of finance obligations, partially offset by$17.0 million in proceeds from a draw down on our line of credit (which was used for the retirement of long-term debt). Financing activities for the year endedDecember 31, 2010 resulted in net cash outflows of$9.4 million primarily from$24.9 million used for retirement of long-term debt, partially offset by$16.4 million in proceeds from finance obligations (which were primarily used for retirement of long-term debt) and$1.5 million in proceeds from the exercise of stock options.
Redeemable common stock
InJune 2009 , we discovered that we had inadvertently issued 203,737 more shares of our common stock in connection with our 401(k) plan than had been registered with theSecurities and Exchange Commission for offer in connection with the 401(k) plan. These shares were contributed to or otherwise acquired by participants in the 401(k) plan betweenAugust 16, 2006 , andJune 17, 2009 . As a result, certain participants in the 401(k) plan may have had rescission rights relating to the unregistered shares, although we believe that the federal statute of limitations applicable to any such rescission rights would be one year, and that the statute of limitations had already expired atJune 30, 2009 with respect to most of the inadvertent issuances. OnAugust 31, 2009 , we entered into a Tolling and Standstill Agreement (the "Tolling Agreement") with theOverstock.com, Inc. Employee Benefits Committee (the "Committee") relating to the 401(k) plan. We entered into the Tolling Agreement in order to preserve certain rights, if any, of plan participants who acquired shares of Overstock common stock in the plan betweenJuly 1, 2008 andJune 30, 2009 (the "Purchase Period"). InAugust 2010 , we made a registered rescission offer to affected participants in the plan who acquired shares of Overstock common stock during the Purchase Period. The rescission offer applied to shares purchased during the Purchase Period at prices ranging from$6.77 per share to$21.17 per share. OnOctober 6, 2010 , our rescission offer expired. As a result of the offer, we repurchased 1,202 shares of common stock for$26,000 . OnOctober 14, 2010 we terminated the Tolling Agreement. AtDecember 31, 2011 none of our shares were classified outside stockholder's equity due to the expiration of potential rescission rights associated with those common shares. AtDecember 31, 2010 approximately 46,000 shares or$570,000 of our common stock plus interest were classified outside stockholders' equity, respectively.
Stock and Debt Repurchase Program
We retired$34.6 million of the Senior Notes during the year endedDecember 31, 2011 , for$34.6 million in cash, resulting in a loss of$54,000 on early extinguishment of debt, net of$77,000 of associated unamortized discount. Of the$34.6 million in Senior Notes retired during the year endedDecember 31, 2011 ,$10.1 million were held byChou Associates Management Inc. or an affiliate of Chou ("Chou") and$21.7 million were held by Fairfax Financial Holdings Limited or an affiliate of Fairfax ("Fairfax"). Chou and Fairfax are beneficial owners of more than 5% of our common stock. We retired$25.4 million of the Senior Notes during the year endedDecember 31, 2010 for$24.9 million in cash, resulting in a gain of$346,000 on early extinguishment of debt, net of$158,000 of associated unamortized discount.
As of
During the years endedDecember 31, 2011 and 2010, we withheld from vesting restricted stock awards a total of 100,000 and 63,000 shares of our common stock for$1.6 million and$825,000 , respectively. The shares withheld represented the minimum tax withholdings upon the vesting of those restricted stock award grants to satisfy the minimum tax withholdings owed by the grantee of the restricted stock award grant. None of these shares were repurchased in the open market. 72
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Contractual obligations and commitments
The following table summarizes our contractual obligations as of
Payments Due by Period
Contractual Obligations 2012 2013 2014 2015 2016
Thereafter Total Capital lease obligations 116 3 - - - - 119 Line of credit 17,000 - - - - - 17,000 Interest on line of credit 519 - - - - - 519 Operating leases 8,916 8,206 8,404 6,818 1,381 183 33,908 Naming rights 1,236 1,273 1,311 1,351 1,391 - 6,562
Purchase obligations 14,342 - - - -
- 14,342 Total contractual cash obligations $ 42,129 $ 9,482 $ 9,715 $ 8,169 $ 2,772 $ 183 $ 72,450 Amounts of Commitment Expiration Per Period Other Commercial Commitments 2012 2013 2014 2015 2016 Thereafter Total Letters of credit $ 2,028 $ - $ - $ - $ - $ - $ 2,028 Naming rights During 2011, we entered into a six-year agreement with theOakland-Alameda County Coliseum Authority ("OACCA") for the right to nameOakland Alameda County Coliseum . Amounts represent annual payments due OACCA for the naming rights and we may terminate this agreement at our sole option, subject to its termination fee. Purchase Obligations
The amount of purchase obligations shown above is based on assumptions regarding the legal enforceability against us of purchase orders we had outstanding at
Tax Contingencies
Our contractual obligations presented above exclude unrecognized tax contingencies, including interest and penalties, of$313,000 for which we cannot make a reasonably reliable estimate of the amount and period of payment. For further information regarding the application of ASC 740-10-5, see the information set forth under Item 15 of Part IV, "Financial Statements-Note 20-Income Taxes," contained in the "Notes to Consolidated Financial Statements" of this Annual Report on Form 10-K.
Recommendation Algorithm Development Costs
During 2011, we announced two contests offering cash prizes of up to$1.3 million for each contest period to the researcher or research team who can design and develop a recommendation algorithm which provides a minimum of 1% increase in sales as compared to our existing algorithm. The contest periods endMarch 31, 2012 andSeptember 30, 2012 and the cash prizes, if any, would be awarded at those times. 73
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Borrowings
U.S. Bank Financing Agreements
We are a party to a Financing Agreement withU.S. Bank National Association ("U.S. Bank ") datedDecember 22, 2009 (as amended to date, the "Financing Agreement"). The maximum credit potentially available under the revolving facility is$20 million . Our obligations under the Financing Agreement and all related agreements are secured by all or substantially all of our assets, excluding our interest in certain litigation. Subject to certain exceptions, the full amount of the revolving facility is expected to be available to us as long as$20 million in the aggregate is maintained on deposit withU.S. Bank . AtDecember 31, 2011 and at the date of this report we maintained$20 million on deposit withU.S. Bank . The obligation ofU.S. Bank to make advances under the Financing Agreement is subject to the conditions set forth in the Financing Agreement. Our failure to keep at least$20 million on deposit in certain accounts withU.S. Bank would constitute a "triggering event" under the Financing Agreement. If a triggering event occurs, we would become subject to financial covenants (i) limiting our capital expenditures to$20 million annually, and (ii) requiring us to maintain a Financing Agreement defined fixed charges coverage ratio of at least 1.10 to 1.00 as of the end of any fiscal quarter for the period of the prior four quarters. The occurrence of a triggering event could also result in a decrease in the amount available to us under the non cash-collateralized portion of the facility, as availability would then depend, in part, on the Borrowing Base (as defined in the Financing Agreement). The stated termination date of the Financing Agreement isDecember 31, 2012 . The maximum amount potentially available under the Financing Agreement is$20 million , limited to$3 million for cash-collateralized letters of credit and other financial accommodations, and$17 million for advances supported by our non-cash collateral. As permitted by the Financing Agreement, during the year endedDecember 31, 2011 , we used the entire$17 million available for advances supported by our non-cash collateral to fund the redemption of our then-outstanding Senior Convertible Notes dueDecember 1, 2011 . Advances under the Financing Agreement bear interest at one-monthLIBOR plus 2.5%. The interest rate for borrowings under the Financing Agreement was 2.75% atDecember 31, 2011 . We have also entered into an interest rate cap agreement withU.S. Bank with an effective date ofOctober 1, 2011 limiting our exposure for one-monthLIBOR at 0.5% for the term of the Financing Agreement. The Financing Agreement includes affirmative covenants and negative covenants that prohibit a variety of actions without the approval ofU.S. Bank , including, without limitation, covenants that (subject to certain exceptions) limit our ability to (a) incur or guarantee debt or enter into indemnity agreements, (b) create or permit liens, (c) enter into any merger or consolidation or purchase or otherwise acquire all or substantially all of the assets of another person or the assets comprising any line of business or business unit of another person, (d) except for permitted acquisitions, purchase the securities of, create, invest in, or form any subsidiary or other entity, (e) make loans or advances, (f) purchase, acquire or redeem shares of our capital stock or other securities, (g) change our capital structure or issue any new class of capital stock, (h) change our business objectives, purposes or operations in a manner which could reasonably be expected to have a material adverse effect, (i) change our fiscal year, (j) enter into transactions with affiliates, (k) sell assets except for the sale of inventory in the ordinary course of business, (l) permit judgments to be rendered against us in excess of certain limits or having specified effects, depending in part on whether a triggering event has occurred or would occur, (m) take certain actions regarding our receivables, and (n) take certain actions regarding our inventory. During 2011, we were out of compliance with two covenants and obtained waivers fromU.S. Bank for these covenant violations. 74
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Amounts outstanding under the Financing Agreement atDecember 31, 2011 andDecember 31, 2010 were$17.0 million and zero, respectively, and letters of credit totaling$2.0 million and$2.4 million , respectively, were issued on our behalf collateralized by compensating cash balances held atU.S. Bank , which are included in Restricted cash in the accompanying consolidated balance sheets. AtDecember 31, 2011 , we had$20.0 million in compensating cash balances held atU.S. Bank . If we draw on the$20.0 million compensating cash balance, it will constitute a triggering event and result in additional and more restrictive covenants. Prior toDecember 27, 2011 , we were a party to a Master Lease Agreement and a Financial Covenants Rider and related documents (collectively, the "Master Lease Agreement") datedSeptember 17, 2010 withU.S. Bancorp Equipment Finance, Inc. -Technology Finance Group ("Lessor"), an affiliate ofU.S. Bank National Association . Under the Master Lease Agreement we entered into four separate leases, pursuant to which we sold certain information technology hardware ("IT Assets") to Lessor, which were simultaneously leased back for a period of 48 months and financed certain software licenses for a period of 48 months for proceeds totaling$16.4 million . Subsequently, we entered into eleven additional leases; whereby we leased$8.2 million in IT Assets and financed certain software licenses directly from the Lessor. We had the right to repurchase the IT Assets at the end of the 48-month term for$1.00 . Payments on the Master Lease Agreement were due monthly. The weighted average effective interest rate under the Master Lease Agreement was 6.29%. We had accounted for the Master Lease Agreement as a financing transaction and amounts owed are included in Finance Obligations, current and non-current in the consolidated balance sheets. We recorded no gain or loss as a result of entering into these transactions. OnDecember 27, 2011 , we and the Lessor agreed to terminate the Master Lease Agreement and all related schedules. We paid approximately$20.1 million to Lessor in connection with the amendment and agreement to terminate the Master Lease Agreement, resulting in a$1.2 million loss on early retirement of debt included in Other income (expense), net in our consolidated statements of operations. As ofDecember 31, 2011 andDecember 31, 2010 , zero and$16.1 million of the finance obligations remained outstanding, respectively.
U.S. Bank Purchasing Card Agreement
We have a commercial purchasing card (the "Purchasing Card") agreement withU.S. Bank . We use the Purchasing Card for business purpose purchasing and must pay it in full each month. AtDecember 31, 2011 ,$3.4 million was outstanding and$1.6 million was available under the Purchasing Card. AtDecember 31, 2010 ,$2.7 million was outstanding and$2.3 million was available under the Purchasing Card.
3.75% Convertible Senior Notes
InNovember 2004 , we completed an offering of$120.0 million of 3.75% Convertible Senior Notes due 2011 (the "Senior Notes"). Proceeds to us were$116.2 million , net of$3.8 million of initial purchaser's discount and debt issuance costs. The discount and debt issuance costs were being amortized using the straight-line method which approximates the effective interest method. We recorded amortization of discount and debt issuance costs related to this offering totaling$77,000 ,$228,000 and$331,000 during the years endedDecember 31, 2011 , 2010 and 2009, respectively. Interest on the Senior Notes was payable semi-annually onJune 1 andDecember 1 of each year. The Senior Notes were scheduled to mature onDecember 1, 2011 and were unsecured and ranked 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. We retired all of the remaining$34.6 million of the Senior Notes during the year endedDecember 31, 2011 , for$34.6 million in cash, resulting in a loss of$54,000 on early extinguishment of 75
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debt, net of$77,000 of associated unamortized discount. Of the$34.6 million in Senior Notes retired during the year endedDecember 31, 2011 ,$10.1 million were held by Chou and$21.7 million were held by Fairfax. Chou and Fairfax are beneficial owners of more than 5% of our common stock. We retired$25.4 million of the Senior Notes during the year endedDecember 31, 2010 for$24.9 million in cash, resulting in a gain of$346,000 on early extinguishment of debt, net of$158,000 of associated unamortized discount.
As of
Off-balance sheet arrangements
We do not have any off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources that would be material to investors. Non-GAAP financial measures
Regulation G, Conditions for Use of Non-GAAP Financial Measures, and other
Contribution (a non-GAAP financial measure) (which we reconcile to "Gross profit" in our statement of operations) consists of gross profit less sales and marketing expense and reflects an additional way of viewing our results. Contribution Margin is Contribution as a percentage of revenues. When viewed with our GAAP gross profit less sales and marketing expenses, we believe Contribution and Contribution margin provides management and users of the financial statements information about our ability to cover our operating costs, such as technology and general and administrative expenses. Contribution and Contribution Margin are used in addition to and in conjunction with results presented in accordance with GAAP and should not be relied upon to the exclusion of GAAP financial measures. You should review our financial statements and publicly-filed reports in their entirety and not rely on any single financial measure. The material limitation associated with the use of Contribution is that it is an incomplete measure of profitability as it does not include all operating expenses or non-operating income and expenses. Management compensates for these limitations when using this measure by looking at other GAAP measures, such as operating income (loss) and net income (loss). For further details on Contribution, see the calculation of this non-GAAP measure below (in thousands): Year ended December 31, 2011 2010 2009 Total revenue $ 1,054,277 $ 1,089,873 $ 876,769 Cost of goods sold 875,189 900,233 712,017 Gross profit 179,088 189,640 164,752 Less: Sales and marketing expense 61,813 61,334 55,549 Contribution $ 117,275 $ 128,306 $ 109,203 Contribution margin 11.1 % 11.8 % 12.5 % Free Cash Flow Free cash flow (a non-GAAP financial measure) reflects an additional way of viewing our cash flows and liquidity that, when viewed with our GAAP results, provides a more complete understanding of factors and trends affecting our cash flows and liquidity. Free cash flow, which we reconcile to "Net 76
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cash provided by (used in) operating activities", is cash flows from operations reduced by "Expenditures for fixed assets, including internal-use software and website development." We believe that cash flows from operating activities is an important measure, since it includes both the cash impact of the continuing operations of the business and changes in the balance sheet that impact cash. However, we believe free cash flow is a useful measure to evaluate our business since purchases of fixed assets are a necessary component of ongoing operations and free cash flow measures the amount of cash we have available for future investment, debt retirement or other changes to our capital structure after we have paid all of our expenses. Therefore, we believe it is important to view free cash flow as a complement to our entire consolidated statements of cash flows as calculated below (in thousands): Year ended
December 31,
2011 2010
2009
Net cash provided by operating activities $ 25,663 $
16,322
(8,741 ) (20,511 ) (7,275 ) Free cash flow $ 16,922 $ (4,189 ) $ 38,842 77
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