Overstock.com 2006 Annual Report Download - page 49

Commentary—Gross Margins. We consciously and aggressively discounted older inventory during the fourth quarter, and as a
result, our direct gross margins were negatively impacted. However, we did this to significantly clean and reduce our inventory in an
effort to reduce the overall SKU (stock keeping unit) count on our website and to refine our product selection to categories that turn
faster and have higher profitability. We believe that we can run our direct business with less inventory than we have had in the past,
while filling in product selection using fulfillment partners, rather than acquiring the inventory directly. As a result of these efforts, we
believe that we should see a significant improvement in direct and overall gross margins beginning in the first quarter of 2007. With
reduced inventory levels, we now have excess warehouse capacity, and we are therefore making efforts to reduce warehouse space.
We believe that we will see additional improvement to direct gross margins if and when we are able to successfully do this.
Commentary—Marketing. Our intent in 2006 was to keep marketing expense as a percent of sales at approximately 7%, and we
had accomplished this over the first six months of the year. We entered the third quarter with our systems and processes running
smoothly, and our customer satisfaction ratings back to where they had been prior to the system issues we experienced at the end of
2005. As a result, we increased both online and offline marketing expenditures in the last half of 2006 in an effort to create sales
momentum in Q4 2006 and into 2007. However, we did not see a corresponding increase in revenue, primarily as a result of visitor
conversion rates, and marketing expense ended at 9% of sales for the year.
We believe that our marketing expenditures were also less efficient due to overall increases in online marketing rates, as well as
the expiration of marketing agreements we had with several large portals, including MSN, Yahoo and AOL, which are either no
longer available or are too expensive for us to justify. In an effort to offset this, we have internally developed a search engine
optimization tool that we believe will help us manage keyword purchases more efficiently. We intend to reduce our marketing
expenditures as a percent of sales in 2007 below the 9% we spent in 2006.
Commentary—Technology and G&A costs. Through 2004, we were growing rapidly (over 80% year-over-year) and had reached
$495 million in revenue, yet we had invested less than $25 million into our systems and infrastructure. We believed that we would
continue to see rapid growth and therefore made significant investments into our facilities, system infrastructure and warehouse space,
just as sales growth stopped. As a result, our expense structure is higher than is necessary for our current revenue level, and therefore
we have begun efforts to decrease our operating expenses. We have reduced our headcount from 864 at December 2006 to 725 at
February 2007. We have terminated an expensive computer co-location facility lease. We are in the process of significantly reducing
additional facilities and warehouse lease costs and other expenses. Among other things, we intend to move our corporate offices into
existing space in our main Salt Lake City warehouse. As a result of these efforts, we expect our technology and G&A costs to
decrease in 2007.
Commentary—Balance Sheet Items—We ended 2006 with $20 million of inventory, significantly lower than the $93 million we
had at the end of 2005. From this lower inventory level, we expect to turn our inventory much more efficiently. We have entered 2007
with more attractive, higher margin inventory, and as a result, we expect our gross margins in 2007 to increase significantly over 2006
levels. In addition to converting much of our inventory into cash, we also raised $40 million in common equity in December (for a
total of $64 million in common equity raised during 2006), greatly improving our cash position, which ended the year at $127 million.
At current inventory levels, we anticipate that we may require less capital to run our business in 2007. However, whether we will need
to raise additional capital will depend on, among other things, our revenues, gross margins, product sales mix and expenses.
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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