Overstock.com Inc (OSTK) 2006 Q1 法說會逐字稿

Good day, ladies and gentlemen. Thank you for your patience, and welcome to the first-quarter 2006 Overstock.com, Inc. earnings conference call. At this time, all participants are in a listen-only mode. However, we will be facilitating a question-and-answer session towards the end of today's conference. (OPERATOR INSTRUCTIONS). As a reminder, today's conference is being recorded for replay purposes.

I would now like to turn the conference over to your host for today's presentation, Mr. David Chidester, Senior Vice President of Finance. Please proceed.

Thank you. Good morning and welcome to Overstock.com's first-quarter 2006 conference call. Participating with me on the call today is Dr. Patrick Byrne, Chairman and CEO of Overstock.com.

Please keep in mind that the following discussion and the responses to your questions reflect management's views as of today, April 28, 2006, only. As you listen to the call, I encourage you to have our press release in front of you, since our financial results, detailed commentary and the letter to shareholders are included, and will correspond to much of the discussion that follows.

As we share information today to help you better understand our business, it is important to keep in mind that we will make statements in the course of this conference call that state our intentions, hopes, beliefs, expectations or predictions of the future. These constitute forward-looking statements for the purpose of the Safe Harbor provisions under the Private Securities Litigation Reform within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. These forward-looking statements involve certain risks and uncertainties that could cause Overstock.com's actual results to differ materially from those projected in these forward-looking statements. Overstock.com disclaims any intention or obligation to revise any forward-looking statements. Additional information concerning important factors that could cause actual results to differ materially from those in the forward-looking statements is contained from time to time in documents that the Company files with the SEC, including but not limited to its most recent reports on Forms 10-K, 10-Q, 8-K and S1.

I will now turn the call over to Patrick.

Thank you, David. There were 40 people on the call, but they said several hundred were trying to log in. And rather than delay, we will try to start and I will just spend the first few minutes talking about this crusade, which is, I know, something people always ask me about privately, not publicly. And that will give time for the operators to log in what I understand is a very big queue. So I will just vamp 'til ready a bit, telling you my thoughts on this.

One is I know that some will say this crusade is a betrayal of my responsibility as a CEO. I could say that I'm certain that it isn't, and I would be almost completely truthful. I could say that the crusade doesn't interfere with my duties as a CEO, and that would be largely truthful. But the simple truth is, I think we in the financial community are living over a deep fissure. I'm not happy about it, I lose sleep about it, and as everyone knows, I'm in quite a donnybrook about it. This is a moment where I can talk to you without being filtered through a few dishonest journalists.

The simple problem is there's a number of ways in which stock trades can fail to settle, or there can be an expansion in the number of shares or share-like things. There are failed short sales, which are the famous naked short, which I don't even think is the bulk of the problem. I think it's a lot less than half the problem. There's failed long sales, open positions at the DTCC, desk trades at the brokers, share entitlements, which are very slippery. I call all these phantom shares -- not to be outrageous, but I'm saying on the one hand, there's a number of shares that the Company issued and which have been borrowed once and sold again. And so they have a clear chain of title. And then there's the total number of shares that the world thinks they own, and there's a difference between the two, in some companies. And whatever that difference is, it's -- you can call it phantom shares. And I'm saying that they represent three problems.

One, it has blown our system of corporate governance. The current issue of Bloomberg Magazine has a fantastic article about this, with a whole bunch of people from the back office of Wall Street, the securities transfer people. And they are talking about how votes are cast twice, and one guy says votes are cast twice on almost every matter of substance. It definitely can and does, in my experience, affect the outcome of corporate elections. Well, you can't hold corporate elections if people in the back office are just throwing out extra proxies to make votes tally. I thought of doing some kind of -- look, I'm sure many people on the phone or who will join this call had problems getting their proxies. We don't know what that -- we mailed amount them out within the window. Everyone should have gotten them. I heard some complaints. I'd like to know how many people -- of course, we can't find out how many people really got proxies.

I thought, actually, about putting up some sort of nonbinding public referendum to my shareholders on the subject of should I be fighting this crusade or not. I figured that I would probably get 65% of my shareholders saying they are against it, and I'd get the other 210% would be for it.

The second thing it does is the market -- these phantom shares distort a market price. The orthodox response is that can't happen. If unsettled trades are dumped into the system, the market can't move very far before some ocean of money comes in to support it. The orthodox answer is right if you are talking about IBM. But if you're talking about a fledgling firm paddling into the market and somebody dumps a bunch of phantom shares into its market, of course it can be capsized. Everyone on the phone has taken economics. Stock in an illiquid market will act like a commodity. Phantom shares will shift the supply curve to the right. That will collapse the [equilibrium] price, which the guy selling fake Rolexes on the street in front of you can explain. It doesn't happen with IBM, but it can happen with startup companies, software firms, drug companies, especially if they are businesses about which it's easy to confuse the public, which it's easy to do if you have a stable of captive reporters to whom you can dictate what you want written.

Speaking of which, I want to correct something. Over and over, you see reporters saying Byrne blames his stock price on naked shorting. That's a lie. And you'll notice that none of the guys who attribute that to me -- guys and gals -- ever have a quote supporting it. I have never even lamented Overstock's price. I've never come out and said we're undervalued; that's a lie. I've never discussed Overstock's valuation within the context of naked shorting or said that naked shorting has driven our stock down.

The journalists that write those articles and repeat it with carrot-like -- they repeat it, never have a quote to support it. And Holman Jenkins in a recent Wall Street Journal article actually went so far as to fabricate a quote. I mean, he repeated all the standard party lines, and he actually fabricated a quote that said, "If I'm crazy, why am I running a public company?" or something like that. That quote was completely fabricated, doesn't resemble, is not a paraphrase of anything I've ever said. And he very artfully constructed the sentence so that when I went back at him I'm sure he will say, "Oh, well, that was a hypothetical quote. It wasn't a fabrication; it was a hypothetical quote." But he was lying when he said that. I mean, this has really gotten strange, when you have got columnists in the Wall Street Journal fabricating quotes out of thin air.

Third, the real problem is I think that unsettled trades may be collectively compromising the system. Why do I think that? Well, for one thing, the SEC says on its own website when they explain why they grandfathered, in January '05, all sale deliveries, they say the grandfathering provisions of regulations [show] were adopted because the Commission was concerned about trading volatility where there were large pre-existing open positions. Now, those would be the same large pre-existing open positions that people say I'm nuts to believe in.

Because the SEC acknowledges that it can't clean up the problem for fear of the volatility. That would -- if they force these unsettled trades to close -- I think that's my point. Beyond the SEC, there has been a bunch of economists like [Robert Shapiro], [Leslie Bonnie], who have studied this and written interesting papers.

The deep problem is the DTCC is a -- we have a clearing system. The DTCC -- it's an opaque corporation owned by the banks that use it, in proportion to their use, i.e., therefore, Goldman and a few others. The SEC, by all accounts, sends over junior regulators who say, how does the SEC do its job? Okay. Are you doing it? It's not even clear that the SEC gets that much corporation. It's an SRO except on the days when it isn't. When the DTCC gets subpoenaed by state regulators, it just rips them up. And it clears 30 times the world's gross world product. So it's owned by the people who profit if it turns a blind eye to issues like, do they deliver things when they sell them? So in a nutshell I say, does that sound kosher? Does that sound like the right way to organize affairs?

So look, I didn't want to fight this fight. I know it sounds corny. It was my dharma to fight this fight. I'm telling you there's a crack in the financial system. It's filling up with phantom shares until they so warp the market the SEC is saying it has to grandfather the unsettled trades for fear of the volatility, for fear of creating volatility with their large pre-existing open positions. So what you think they are talking about? What does it mean when the regulator says there's large amounts of unsettled trades in the system, and if we force them to settle it would create volatility extreme enough that we, the SEC, are afraid to make people do it. Does that say anything to anybody ne here?

So, I'm sure Roddy Boyd of the New York Post and others will have a field day with what I said already. "Oh my god, he said kosher, he said dharma. What a nut. That signifies something." I'm sure it signifies something. As I said, life for them must be doing Cats over and over again. And of course, the New York Post is for folks who move their lips when they read People.

But in closing, these guys can laugh all they want. I think that -- first, I don't think I seem like a guy who cares a whole lot about what other people think of me. The financial community can continue its "apres moi, le deluge" mentality. But I think you ought to ask yourself, what is the world going to look like if I turn out to be right?

Now the punchline is, I am right. And I think that folks are going to start finding that out practically any moment now, that I'm right about a lot of this.

So I've given ten minutes. We should have given time for the operators to process the long queue that I was told existed. We will go to the Company. I told you we ran into a ditch. It's going to take us the first two quarters at least to get out of the ditch and, I think, the third to get back with momentum. We grew 9% and lost $16 million.

In the second quarter, we are going to lose about $16 million. And when I say that, by the way, I mean if it were 20 million, if I thought we were going to lose 20 million, I would say we are going to lose somewhat more than 16 million. I think that we're going to lose 14 to $18 million, in the second quarter. And I think we are going to grow -- growth may pick up a little bit. In the third quarter, we're going to start growing somewhat faster again, and losses will come down. I think in the fourth quarter we start making good money, and then we have our momentum back up.

I'm going to go through a slide deck, as always. I feel like I've driven around with a foot off, to try to let the public see what goes on here. So I have some detailed slides about some of the inner workings that I will be exposing in a moment.

But first, David, why don't you walk through what you want to walk through?

Okay. I'll walk through some of the financial results of the first quarter. And I note that all comparisons that I make will be against our results from the first quarter of 2005, unless otherwise stated. Total revenue was 180 million, an increase of 9%. Gross margins were 14%, down 90 basis points. Gross profit dollars were basically flat, at around 25 million. Sales and marketing costs were down to 7.3% of sales. That's 280 basis points improvement from last year. And this is a reflection of a 22% decrease in overall marketing expense year over year.

However, technology and G&A expenses combined were 15% of sales in the quarter, compared with 7% last year. And with the significant investment we made in technology and G&A during 2005 to support future growth, we began 2006 with a much larger expense structure. This, combined with slowing growth, will result in a significant increase to technology and G&A as a percent of sales for the first nine months of 2006.

A big portion of the increased expense structure is depreciation. Total depreciation was approximately 7 million this quarter, and should be around 30 million for the year. In addition, almost 1 million of the tech and G&A expense in the quarter is for stock-based compensation, as we will now record stock option expense in accordance with FAS 123(R). Although we have never been proponents of EBITDA, I will point out that between depreciation and options expense, approximately 35 million of our expense structure in 2006 will be non-cash.

Total operating expenses grew 42% to 40 million, which translated into a $15 million operating loss or 8.3% of sales. Our net loss was 15.9 million, 8.8% of revenue and $0.82 per share, compared to a 22% loss per share last year. We ended the quarter with cash and marketable securities of 52 million and an additional 30 million of availability on our lines of credit, for a total of 82 million of cash plus availability. Cash at the end of the quarter included 49 million of foreign currency bonds that were meant to mature this fall. However, subsequent to the end of the quarter, we sold the foreign bonds, turned them back into cash. In addition, we plan further reductions in inventory over the next three to four months, which will also enhance our liquidity.

Lastly, operating cash flow during the quarter were an outflow of 73 million, and free cash flows were an outflow of 80 million. For the trailing 12 months, cash flows from operations were an outflow of 44 million and free cash flow was an outflow of 82 million.

You will find additional quarterly metrics on our investor relations website. With that, I will turn the call back to Patrick.

Thank you, David. I will explain what the first slide is going to show you. It's going to show you a chart of our order management score, and this is one of the things that actually got Jason out of his semi-retirement. We have a way of scoring what -- basically, what we think of as aggravation points to the customer. And it's a very big matrix that says, if this order has been late for this kind of reason, for this many days, how many points it is per day and everything. So it's easy to rack up a lot of points when you're doing 20, 30,000 orders a day or 50, 60, 70,000, as we were in the fourth quarter.

Of course, our ERP system came in August/September, is when everything started to unspool. So, when we started calculating the score, we were well over about 1.5 million points. We have it down to 15,000 points now. What that means, it has been 99% cleaned up. And 15,000 points may even sound like a lot, but it can be -- a small number of orders can generate hundreds of points. So we really do have things like 99.8% tight; in fact, I think they are tighter than they ever were before.

Next, on slide 5, marketing efficiency -- we spent 22% less on marketing, at 9% growth -- nothing stellar, but it is interesting. We just had a vendor who does a lot of good statistical analysis do a huge multivariate regression going back several years on all this different spending and how it has affected growth. And what she came up with was -- and we had been operating on some -- really, two sets of very basic rules that could be explained in -- each one of them can be explained in five minutes, and I probably have explained them at times.

And just with these very simple rules, it determines how much we spend, how we rack it between online and offline and then, online, how we chop it up within online spend. We didn't have a good rule for how we handle offline. But still, she came back with a multivariate regression that said -- it turned out we had gotten it -- her numbers came out surprisingly close to ours, is all.

Page six -- net promoter score. We have started paying -- I'm not a big businesses [fab] guy, but there's a book that has really impressed me by Fred Reichheld, the same guy who did The Loyalty Effect ten years ago, which is quite -- if you read about CRM and the value of loyalty and the lifetime value of customer and stuff, a lot of that came out of the book, The Loyalty Effect, or at least he tied it together. He's come out with a new book called The Ultimate Question that seems quite plausible. And it's that you count your net promoters, and that is the people -- a promoter -- you ask people, would you recommend me to a friend, our company to a friend, ranked 1 to 10? And you take the people who are 9's and 10's, and you subject the 1's through 6's, and you get your net promoters. And it just explains a lot of the variation in results.

Again, on page six, we took off the ordinate. I can say that, according to his book, the average American Corporation is under 10%; I think he says 8% or something somewhere. And the superstars are in the high 30's to 80's. We have -- surprisingly, to me, even in our dip, it turned out we were in that band. We have taken out -- we don't want to give the precise number, but we -- it just seems like a very -- you do see the dip, starting last August, and what happened. And we just -- I mean, it breaks my heart, because we spent so much time trying to service millions of people in years past. But this last year we had that problem.

Customers have stuck to us, and it has bounced back to be almost as high as it ever was. And now that we are measuring and managing to this number, I do expect it to get significantly better. I expect it to keep on improving, and I think there is actually a one to two-month lag effect [it seems]. So this -- if I really compare it with the numbers in his book, this is in the upper half of the sort of total superstar score. So we seem to have a lot of happy and loyal customers.

Page seven -- we have gotten really focused on the customer satisfaction. We have restructured this CS organization. We are focusing on agent training, quality. We have contracted, as has been announced, with RightNow, we have decided to go with. Until now, we have been operating customer service on a package that literally Sam Peterson wrote back in the summer of 2000, in the space of a couple of weeks. That has been our customer service app.

This is our last sort of -- sometimes, I think of the last year as a big/prop jet conversion. And, like the airplanes in the '60s that went through prop to jet conversion, we have gone through a prop to jet conversion. And Sam's home-grown system, while fine, was inadequate for the size and the kind of features we need here. So when that gets live, which should be in June, there's -- right now, customer service is costing over 2.5% of sales. I think it's possible to get that to 1%. I've heard that other companies -- I've heard that Amazon is less than that. But I think it's possible -- it's actually around 1.8% -- 2.8% in the first quarter. And that was the right thing to do; it was a little bit higher than in the past, but we had to smother our customers with love. But I think it should be possible to get it down at least into the low 1's. That's why I think that there's -- for example, there would be 150 basis points or more to pick up.

Page eight, operations -- upgrade warehouse management system. That's nearly complete, and we are building a mezzanine in the center of our warehouse, a high-density, [pick-face], three-story, 25,000 square foot mezzanine, so 75,000 square foot. We think we're going to be able to condense the 80 or 90% of our [picking to]. Right now, it's been costing us -- last year, it cost us about $3.50 in total variable costs per package. I think it might be possible -- well, it should be possible, I think, ultimately to get that to 2.50. And so that's an average package is about $60. So that's a 1.7% margin increase, except that's on core only. So that translates into, say, a 0.8% increase in overall margin.

So if you wonder where I've gotten these numbers in the past, as we have grown from 9% margin to 14-15, and I keep saying, well, I think there's another 200 or 300 basis points in these areas. Steve Tryon is during a fantastic job managing the logistics chain now and has built a very strong team. Returns processing has also been a big part of this year.

Going forward, page nine, analytics -- Propeller has been integrated sitewide. It's only making recommendations in some parts of the site. There's a new version expected in Q2. We have had to build something that ties together a lot of different, let's say, Propellers and Junior Propeller. But you are seeing it show up more and more in our site. Site design -- we have adopted a system. It's so powerful I don't even want to tell the name of this company, and I know that they are overwhelmed with demand at this point, but a company that helps you in your site design. And we got a 3% lift last month, and I think that there's quite a few -- just by changing one thing, and we are basically doing one big test per month, and optimizing things as we go. And I'd like to think that for several months, at least, there's sort of 3% lifts or more in each one of these changes.

And then CRM -- CRM as applied to e-mail. We have started personalizing e-mail. It is giving us a somewhere between satisfactory and remarkable lift. It's not remarkable, but it's a very solid lift, very measurable. Unfortunately, even with all our new fancy equipment, we could only do 100,000 at first. It just uses so much power to [bake] these e-mails. We're up to about 500,000, and with some changes we've made, we will be able to do 2 million personalized e-mails per day, starting in probably September or October. And that's a good chunk of the 8.5 million e-mails that we do have.

Page ten, page ten and last -- marketing efficiency. Talked about gross margin, gross profit. Well, marketing efficiency going back -- again, we did cut way back on marketing. We have found, from some independent analysis, that we do seem to have the right basic cuts at things, but this analysis suggests to me ways we can tweak things a little bit as well. Our gross margin is -- I think it's going to be stable for the second quarter, as we keep making these changes, but I just gave you the reasons why I think there is 200 or maybe even 300 basis points. I ultimately think this is a 17 or 18% gross margin business, and I think we can get there in the near future. I would like to see, in the fourth quarter, certainly a number around 17.

You'll see us grow more slowly again in the second quarter. 10% growth is fine as we fix all this stuff. Liquidity -- I know folks are talking about liquidity. I don't see -- I was always more comfortable with doing barrel rolls closer to the ground then my passengers. I don't see us as having a liquidity crisis, although two years ago, as I told people, there was a day where we ran things down to $3 million in cash as we built inventory. And everybody -- [I know how it is]. We have a good, precise control on it. But in any case, we are not doing that now.

We have a -- just yesterday, this Lehman bond, this foreign currency bond than Lehman did a great job for us with, that was a basket of eight Asian currencies, we traded out of yesterday for $49.5 million. And we could have waited until September or November and gotten to 50 million, but if you do the time value of money, 49.5 is just as good now. And that is actually going to imply a bit of a pickup. If we had marked -- it was this strange bond that the accounting said is that, even though we knew were getting at least 50 at the end of the period, you marked it down as you went. And as the dollar appreciated, which was a surprise, we have been marking the value of this down a couple, few million dollars, I think about 2.5. So there will be a bit of a pickup there. And so we have the 50 million. We have to pay off some debt with it, but I think we are fine for this year, as far as cash goes.

Okay, so let's go to questions.

(OPERATOR INSTRUCTIONS). Aaron Kessler, Piper Jaffray.

A couple quick questions, one on the customer acquisition costs. Given that the marketing costs decreased pretty significantly to about 7% of revenue, why didn't we see customer acquisition costs come down a little more? It looks like it was pretty flat year over year. And what is your view now, I mean, given that (indiscernible) some of the brand marketing from last year. Did we still see a lift in Q1, as revenue [has only grown 9]%?

David, do you want to talk about customer acquisition costs? I don't have that in front of me.

I think, like Aaron said, it was flat over Q1 of last year, below $20, which is -- it wasn't below $20 all last year, besides the first quarter. I think the reflection of partially just as we get bigger, it's the new customer growth is slowing, so you've got less new customers over the spend that we have. So the mix is moving a little bit more towards repeat business than just new customer business. And that makes sense, now that growth is slowing.

We think that the value of a customer is significantly above $20 for us. So we are fine with that. Now -- and I'm sorry, what was the second part?

The second question is in terms of the brand marketing. What is your sense now from the lift you got from brand marketing over the last couple of years here, and how much of that is translating to maybe the growth in the first quarter?

Well, we know we got -- we have cut way back in the brand marketing. That's where a lot of the cuts have been, and it's trickling along at a much reduced rate than last year, as you may have noticed. But just measured in terms of name recognition and all that stuff, I think we built a very good brand. As I think we've reported, we went to 29% unprompted name recognition over two years.

So I'm in favor of it, but I think we've reached the point where the marketing guys say you go through these different phases -- awareness, acceptance, all this stuff. We clearly have created awareness. We don't need to keep drilling people in the forehead with the same ad over and over, as much as they like Sabine. I think we can go at the other end of the extreme is somebody like Oreo, who just every year takes two weeks and drills the public for two weeks. And everybody remembers Oreo cookies, and that's all they need. We are not there yet, but you will see us stay back, plus the brand advertising is -- we have accomplished what we set out to accomplish, and I think that we can keep it there with a significantly reduced spend.

Doug Anmuth, Lehman Brothers.

A couple questions. My first one is regarding -- it sounds like you have a lot of things going on or that need to get finished, rather, by the June/July time period, like the warehouse buildout and the new customer service application. So I just wanted to get a sense of what your confidence level is that those things actually get done, sort of by the time we would really get into the back half of the year. And then secondly, you gave some pretty -- a rough outlook recently in terms of your saying that you could do breakeven or better EBITDA and operating cash flow for the year. Do those numbers still hold?

Stand by. I'm just making notes. Okay, on getting the customer service and mezzanine thing done, first of all, customer service -- my confidence level is good on that, that we finish -- it's actually supposed to be finished in early June. So I'm confident we can finish in June. Unlike -- it's an ASP model. We went with RightNow's ASP model, which greatly simplifies -- I wish we had done this before -- greatly simplifies the whole implementation, and they have sent a first-rate team. And I think that they -- I think we will be one of their larger commercial clients. And they are giving us a lot of attention, and it's -- so far, they have been working on it a month or six weeks, and my impression is a very professional team, and we have the resources.

We're just getting much more organized, so when we do things like this, it isn't, you know, grabbing a couple extra programmers and working it nights and on weekends. A lot of our increase is in technology, technology spend. We just have a lot more technologists and developers and such. So it's getting to look more like a real company, when we do things like this. But if there's any (technical difficulty) I would say it's RightNow, just because of it's the nature of any software implementation, customer service app. You know, you can always imagine that running over.

So I can imagine that running over. The mezzanine -- no. The mezzanine is bolting things together. It's funny that you ask that. We actually have a truck full of important parts trucking in through -- coming in from L.A. through southern Utah, ran into a cow and tipped over the cab, and that actually, literally, has stopped the project for two weeks. But short of any more cows on the interstate, I don't see how that gets delayed. That's just bolting things together.

As far as breakeven, definitely -- breakeven on an EBITDA basis, definitely. It would be hard for us to break even on a GAAP basis. But with 35 million of depreciation and amortization, adding that back into the -- I would imagine, yes, we should be breakeven or do better.

David, do you want to follow up on it?

Yes, I think, when you look at breakeven cash flow, I still think we can get there. If you look at the last 12 months. Well, trailing 12 months, operating cash flow is a negative 44 million; 31 million of that is just inventory. We are just a lot deeper in inventory than we were last year. We believe we can run the business with much less inventory. So if we can bring that inventory number down, in particular, we do believe we can be breakeven cash flow for the year.

Yes, one of the things -- let me comment on that, because we were -- our electronic data warehouse, on the one hand, didn't giving us everything that we started off expecting from it. But what it did do was it saved our bacon in the whole ERP problem because, as the ERP system sort of spewed everywhere, we caught it all within the electronic data warehouse, and it really saved us there. But we still have, I think, three or four months left, and we have a very good -- we've built an electronic data warehouse team, a lot of guys from Teradata and from other good companies, big retailers whose names you would know, with a lot of good experience, who are -- it's all bolted together, and it has been working. But I would say that if what we used to have in our homegrown systems was a 10, and our new systems they are probably a 6 to an 8, in terms of our business intelligence. But I think they are on their way to a 15 or to a 20. And meanwhile, our old systems that were on a 10 were failing, as we know. But one of the first things that they have done that's been very powerful was to let us do much more sophisticated inventory analysis, and we would just see that we really think we should be able to squeeze a lot out of our inventory. Now, we always -- I think we show you -- what did we show you, 81 million ending the quarter? David?

Yes, of inventory, yes.

And now that includes 7 million of diamonds, and I just had an offer last week to liquidate the diamonds. If I ever want to get out of them, I can liquidate them at a profit. So we sort of think of our inventory separately from the diamonds. So 74 million, so that 74 million is already down -- I wouldn't be surprised -- it's already down in the mid 60's, and I would imagine it ended the quarter in the low 60's. And I really think that from the analysis we are getting now, it may be possible to squeeze ten -- I don't want to overstate it, but I actually think that the analysis suggests we can squeezes several tens of millions of more out of the inventory, with the business intelligence we now have. So, in that sense, the systems actually paid for themselves.

So, anyway, to go back to Dave's point, yes, we had a 43 million negative operating cash flow in the last 12 months. That's because we've gone from 50 to 81 in the inventory; 31 million of that is just inventory creep.

Can I also just ask you -- you mentioned that there was something in terms of site redesign that gave you a 3% lift last month. Can you give us any more detail or insight into that?

Sure. In fact, I'm so excited about it, I hate to -- I don't even want to give this particular company props, because I don't want my competitors knowing about it. But there is a company we are working with that it's got some very cool technology. They actually were the only people doing this, but somebody else just started, a competitor -- some very sophisticated -- it's called genetic algorithms. Well, I guess I've probably just given it away.

But genetic algorithms is a -- the company is called Optimos. And they come in and take a page, and there is a lot of setup time, but they take a page, say, or a product page. And you say, here is five or six different ways I could have the button placed, here's five or six different ways I could have this placed, that placed, and in a sense -- so they take a subset of your traffic. Now, all those different -- there's billions of permutations; if you have 20 different variables with five or six ways each that they can be set, there's billions of permutations. So they run a test on a subset of your traffic for, say, a week. Then they do a multivariate regression -- find, say, the best eight factors. They sort of mate them all together -- since it's a genetic algorithm, they mate them all together and create 1,000 offspring, and then they test that. And you see -- you test that for a week, and then at the end of the week, you take the eight most fit offspring and you mate them together, and you get other 1,000. You do that a few times, and so it evolves into the right combination.

We are doing that one page at a time. There's basically six or seven major pages in our website -- the product page, the home page, departments, categories, subcats, store departments -- and we are going to sort of do that each month, page by page.

I guess it's not really a secret, because I do know that other big names in this field are -- other big names in the industry have their own team, so I haven't really -- it's not like I am giving Amazon a secret. In fact, I know that there's a guy from Amazon, their Chief Scientist, is the guy who setup -- -- their former Chief Scientist, I believe, is the guy who setup the competitor to Optimos.

So this is a sort of leading-edge area. The gains in it seemed pretty substantial, and so we are just going to be doing one. But there's a lot of setup time for each one of these tests. So, Doug, I hope that wasn't more than you wanted to know. But --

No, very helpful, thank you.

(OPERATOR INSTRUCTIONS). Scott Devitt, Stifel Nicolaus.

Two questions, the first on accounts payable in the quarter. The paydown was 64 million; it was up, I think, 170% year over year. I'm wondering what the explanation is there, if it is related to any changes in terms, either with suppliers on the direct inventory or in terms of paying partners more quickly on the commission side. And I had a follow-up.

David, why don't you start off, and then I'll chime in.

A lot of that is just a reflection of the slowing growth, because we are still paying partners the same we have always paid them. We're a little bit ahead on paying partners, just because we have some billing issues with the new ERP system. So we've sort of stayed ahead of the game, made sure we are taking care of our partners. And we have actually paid a few extra days then we normally would have had.

So that accounts for a few million of it. but in general, as growth has slowed, and the mix of our business moved more towards the core business than the partner business last quarter, you did see accounts payable go down more than it has historically.

Because of the ERP problems, we reached a place where it was hard for us to pay precisely. We've been fanatics on paying our -- David's instructions, since the first days, have been we always pay our vendors. I want to have the best reputation with them, because that's the nature of the closeout business, and -- vendors or partners. And in fact, about a year and a half ago, we went to paying them electronically, so it saved five to ten days, because they didn't have to wait for the mail. We started paying them with these little electronic checks, which they love.

When we started having these problems last fall, I said to David, let's pay the high side, whatever we think we owe them, at the end of every two weeks. So we actually got a lot of cash in front of some vendors. And then, in the first quarters, we have been able to sort of tune in and recreate exactly and reconcile sort of more to the penny. It was just good sort of karma to always pay. The truth is we were not able to count iin the payments; we were able to count at our end, but not for them, to reconcile exactly the returns that we had to deduct. So we always just paid them extra. So that has started to come back to us now. Actually, now, we can pay them precisely to the penny. But in the first quarter, we were still ahead a little bit.

We have had some funny things happen. Some of the blackguards, and in this case one of the major primer brokerages, has actually gone to some of our partners and tried to get them to stop. He tries to raise doubts about us, and they seem to be trying to foment a run on the bank kind of situation. One of the three top guys -- fortunately not, obviously, Stifel Nicolaus. So they are out there going to our partners and trying to -- because we have actually had one major, major partner call up and say, you can't believe the call we just got from one of the bulge bracket banks trying to get me to shut you off.

And just a follow-up on the direct gross margin -- it was down 300 basis points. And I think, Patrick, in the letter you noted warehouse cost as being one explanation. And I'm wondering, because the inventory level was high coming out of 4Q, what component of that was pricing just to drain inventory levels as well.

There's definitely a piece of that in the first quarter, and there will be a piece of that in the first part of the second quarter, although we have come out of it now. But we did mark things down in order to flush things through, and so that hurt our margins a bit.

(OPERATOR INSTRUCTIONS). Frank Gristina, Avondale Partners.

Back on the direct business, was free shipping involved at all in the volatility? And just to review, the direct business seems to have a lot of volatility, even year over year in the gross margins. And I guess pricing, warehouse cost -- is shipping an aspect there?

And then building on that, you don't seem to have the volatility in the fulfillment business. So why it wouldn't you just open the doors to fulfillment partners and really try to make that business larger in the mix drive your margins higher?

I'm going to take that and then -- David, do you want to go first?

I'll just comment quickly, and then you can finish. Part of the reason the direct business has some more volatility is that we have our B2B business, we have some BMV -- books, music and video -- that has lower margins. So as those businesses move, and sometimes the B2B business is more moving inventory out, maybe slower moving, lower margin. So, depending on how the BMV core business and B2B businesses move, that could have an effect on the overall margins. So the direct does have some more moving parts than the partner business does.

Although I would say, how I was going to answer was that the pricing is the biggest element in the volatility. The shipping is an element as well, although we're cutting back on the free shipping. We are not using that as extensively. The smallest element of the volatility is the warehouse handling costs. Now, I do think that we're going to be able to take a nice sliver out when we get this new mezzanine finished. But it's not like suddenly the warehouse started running badly; it was much more pricing and changes in our shipping policies and how often and we give dollar shipping and things like that.

As far as partners, we have built to 700 partners. We are about to have, I think, a way to increase that severalfold, if we want.

Is there any reason why you wouldn't want to -- you could still own the customer but just not have to deal with these warehousing and shipping issues.

No, there is no reason we wouldn't want to. There was a reason in the past, and that was we were less confident of our customer satisfaction from partners than we were of ourselves. We now have ways that we are able to measure that, as of a week ago. And we can -- in the middle of May, if we want, we can increase our total number of partners about fivefold. I don't think we're going to increase it fivefold; we don't want to be Yahoo Shops. But we are, I think, on the verge of filling in -- we don't want people just to compete with the current partners, but we think we can fill in -- we're not going to increase it fivefold, but we will have our pick of increasing it in areas where we have not been selling products yet, or have had a very sparse selection. We will be able to increase it with partner products.

But I'm not sure I would see an overall -- other than in those sparse areas, we will get filled out. What we're also learning is not to have too many products. We don't want to -- we wonder now if we may have too many SKUs. And we certainly have discovered that the 20/80% rule is even -- anyway, we're not trying to overwhelm the customer with choice anymore. We're trying to refine it to the best choices.

Jason is on the line. And Jason, as you know, was named President earlier this week. For the old-timers here, Jason was -- I think everybody regretted when Jason retired a few years ago. But I know Jason has some strong thoughts on this. So Jason, why don't you come on the line and answer? First of all, tell the world why you left and why you're back, if you want to, and how you feel about this, because I know you have a lot of thoughts on this question.

Well, to answer the question first, why not just open it up to everybody? I think to answer is, as Patrick said, we don't want to be Yahoo Shops. There's a trade-off between selection and clutter, and that's a fine line which we have spent a lot of time lately looking at. And we're going to try and hit that line as close as we can. But I think you will see more partners come online soon, especially in areas where our selection is limited.

As far as why I left, I left for the reason I said I left; I had health problems in the family. My wife got --

You don't have to go into all that, if you don't want to.

Yes. So I had real health problems in the family, and spent a lot of time in the hospital with the family. But everybody is doing great, and I am happy to report everybody is fine and has been for a while. So I'm anxious to be back, and it's good to be back.

Jason has actually been behind the scenes here the whole time in the sense of, one day a week, coming in and helping at the -- co-presiding with me. He has always really been my Co-CEO, really, since we started the Company. And we just made it official when -- he has come back full-time basically for this year so far, and will be full-time going forward.

Okay. And anything else, Frank?

No, thanks very much.

And that's fair. I mean, we love the partner program. We're starting to love it more, even.

Derek Brown, Pacific Growth Equities.

How much cash do you think you will need to reignite growth for the fourth quarter? And when do you need to have that cash to build inventory and make sure that the store is filled with stocks, the shelves are stocked?

Well, my answer is I don't think we need more cash. I think that we can go into -- I think that we can run our inventory much better than we did before. So in the fourth quarter, if -- what we have now is probably the right amount to enter this fourth quarter with. We had built it up to much in the past, is what we have learned.

Jason, what is your -- I'm sure you have an additional --

Sure. I think we have plenty of cash as well. One thing we learned, obviously, since we have way too much inventory now, is we went through the Christmas season last year with way too much inventory. So if you look back and calculate any kind of ratio of how much inventory do they have going into the season and how much do they need, the season being the Christmas season, I think you'll see that, like Patrick said, the inventory we have on hand now is probably plenty. So we don't really need a bunch of additional excess cash to build our inventory levels. But I do say that I think you'll see over the next few months, we will continue to buy more inventory and sell more inventory. So our mix will change, but I don't think we need a bunch of cash to build our inventory levels.

Would you agree, Jason, that it's going to decline and then swell up again in September/October?

Yes. Absolutely.

I guess we do have time -- is there anyone else, operator?

Actually, that was the last question, sir. We're going to turn it back over to you for final comments.

Okay. Well, as I said -- Jason, do you want to -- why don't you make some final comments?

Well, my thoughts from 30,000 feet are we stumbled and we know we stumbled, and don't let anything we say think we're making excuses or that we don't realize that we stumbled. However, in the long run, it might be a good thing for the business. We grew 100% or something close to that year after year after year. And when we had the debacle we had replacing all of our systems this year, obviously we shrunk a lot. And when you shrink that dramatically that quickly, your financial results look terrible. But it is giving us time to take a deep breath and harden all of our systems.

Historically, when we were growing that fast in the past, we were trying so many things and launching so many new businesses. The thing I'm encouraged about right now is everything that we're focusing on and everything you hear us talking about are all hardening and building the infrastructure for our core internal shopping business. You have not heard us say anything about any other business, other than overstock merchandise to our customers.

And that business is getting a lot of attention. It's getting more attention now than it has ever gotten. And as bad as the systems got, I think Patrick mentioned before, when he was talking about our aggravation point, I think the core shopping business, as far as somebody orders a product and they get it on time -- I'm not sure our business has ever been better. And if now we are spending -- so from the customer side, it's better than ever. From the investor side, the financial side, now we are spending an equal amount of time making sure all the internal systems to make us manage our business and have it be as efficient as it can, just for the core shopping site, it's getting that attention now. So I think investors should be pleased, and in the next six months to a year, you'll see a big difference in our financial performance because of it.

Thank you, Jason. We went a long way on a thimbleful of systems. And I blew it. I should have realized six months earlier than I did that when those systems reached their limit, there were going to reach -- there were going to work until the day they didn't. And then they really didn't work.

So to me, this is all a function of bad decisions I made in the first half of '05, both in that they were belated, and then I made a bunch of them and we tried to throw a bunch of stuff together, and we stumbled. And it's taking us the first quarter, the second quarter and really might as well assume the third quarter to pick ourselves up and dust ourselves off and get going.

And to Jason's point about what -- one of the things we get so excited about is we realize now that it's like the Japanese teach this way of thinking and manufacturing, that you drain the reservoir until some rocks emerge. And then you go in and blast the rocks, and then you drain the reservoir some more until some rocks emerge, and then you blast those rocks.

We had drained the reservoir all we could on our old systems, in the sense of we couldn't have gotten better. We couldn't have gotten better or more refined looks at inventory or more refined looks at marketing. We certainly couldn't have done analytics that underlies personalization and so forth. We couldn't have gotten any better than we were. Yes, there's these transition costs. We've moved to a bunch of big, honking, professional, powerful systems, and off this sort of stuff that was all duct taped and together. But there's transition costs, but now that we are on it, we can drain the reservoir a lot lower than we could have under the old systems, in terms of fixing problems and such.

As Jason pointed out, we didn't even mentioned the other [tabs]. I will mentioned that travel beat budget for the quarter. Auction was just a little bit behind budget. Last year, we lost nearly 5 million on auctions, and the goal this year is, again, to breakeven. I think we should come within at least $1 million of that goal in auctions. And we don't really have any great new businesses planned. We're just refining what we have.

Okay. Well, thank you for sticking with us, the long-term owners. And I'm sure, like me, you welcome having Jason back to provide adult supervision. I look forward to talking to you in three months. And again, expect pretty much the same thing. Expect pretty much the same thing for one more quarter, and then things will start getting better in the third. Thank you.

Thank you very much, sir. Thank you, ladies and gentlemen, for your participation in today's conference call. This concludes your presentation, and you may now disconnect.