Table of Contents

 

 

 

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

 

(Mark One)

 

 

 

 

 

x

 

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934

 

 

 

 

 

For the quarterly period ended June 30, 2008

 

 

 

 

 

Or

 

 

 

o

 

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934

 

 

 

 

 

For the transition period from                         to

 

Commission file number: 000-49799

 

OVERSTOCK.COM, INC.

(Exact name of registrant as specified in its charter)

 

Delaware

 

87-0634302

(State or other jurisdiction of

 

(I.R.S. Employer

incorporation or organization)

 

Identification Number)

 

6350 South 3000 East

Salt Lake City, Utah 84121

(Address, including zip code, of

Registrant’s principal executive offices)

 

Registrant’s telephone number, including area code: (801) 947-3100

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), (2) has been subject to such filing requirements for the past 90 days.  Yes  x   No  o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definitions of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

Large accelerated filer o

 

Accelerated filer x

 

 

 

Non-accelerated filer o

 

Smaller reporting company o

(Do not check if a smaller reporting company)

 

 

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the act). Yes o    No x

 

There were 22,812,317 shares of the Registrant’s common stock, par value $0.0001, outstanding on August 1, 2008.

 

 

 



Table of Contents

 

TABLE OF CONTENTS

 

PART I. FINANCIAL INFORMATION

3

 

 

Item 1. Financial Statements (Unaudited)

3

 

 

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

22

 

 

Item 3. Quantitative and Qualitative Disclosures about Market Risk

41

 

 

Item 4. Controls and Procedures

41

 

 

PART II. OTHER INFORMATION

42

 

 

Item 1. Legal Proceedings

42

 

 

Item 1A. Risk Factors

42

 

 

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

58

 

 

Item 3. Defaults upon Senior Securities

59

 

 

Item 4. Submission of Matters to a Vote of Security Holders

59

 

 

Item 5. Other Information

59

 

 

Item 6. Exhibits

59

 

 

Signature

60

 

2



Table of Contents

 

PART 1. FINANCIAL INFORMATION

 

ITEM 1. FINANCIAL STATEMENTS

 

Overstock.com, Inc.

Consolidated Balance Sheets (unaudited)

(in thousands)

 

 

 

December 31,

 

June 30,

 

 

 

2007

 

2008

 

Assets

 

 

 

 

 

Current assets:

 

 

 

 

 

Cash and cash equivalents

 

$

101,394

 

$

56,679

 

Marketable securities

 

46,000

 

30,020

 

Cash, cash equivalents and marketable securities

 

147,394

 

86,699

 

Accounts receivable, net

 

12,304

 

15,186

 

Notes receivable (Note 4)

 

1,506

 

250

 

Inventories, net

 

25,933

 

14,036

 

Prepaid inventory

 

3,572

 

2,648

 

Prepaid expenses

 

7,572

 

10,481

 

Total current assets

 

198,281

 

129,300

 

Property and equipment, net

 

27,197

 

21,318

 

Goodwill

 

2,784

 

2,784

 

Other long-term assets, net

 

86

 

30

 

Notes receivable (Note 4)

 

4,181

 

4,453

 

Total assets

 

$

232,529

 

$

157,885

 

Liabilities and Stockholders’ Equity

 

 

 

 

 

Current liabilities:

 

 

 

 

 

Accounts payable

 

$

70,648

 

$

31,217

 

Accrued liabilities

 

35,241

 

24,248

 

Deferred revenue

 

17,357

 

15,417

 

Capital lease obligations

 

3,796

 

 

Total current liabilities

 

127,042

 

70,882

 

Other long-term liabilities

 

3,034

 

2,975

 

Convertible senior notes

 

75,623

 

75,795

 

Total liabilities

 

205,699

 

149,652

 

Commitments and contingencies (Notes 7 and 8)

 

 

 

 

 

Stockholders’ equity:

 

 

 

 

 

Preferred stock, $0.0001 par value, 5,000 shares authorized, no shares issued and outstanding as of December 31, 2007 and June 30, 2008

 

 

 

Common stock, $0.0001 par value, 100,000 shares authorized, 25,423 and 25,496 shares issued as of December 31, 2007 and June 30, 2008, respectively

 

2

 

2

 

Additional paid-in capital

 

333,909

 

337,659

 

Accumulated deficit

 

(243,709

)

(254,081

)

Treasury stock, 1,605 and 2,713 shares at cost as of December 31, 2007 and June 30, 2008, respectively

 

(63,278

)

(75,218

)

Accumulated other comprehensive loss

 

(94

)

(129

)

Total stockholders’ equity

 

26,830

 

8,233

 

Total liabilities and stockholders’ equity

 

$

232,529

 

$

157,885

 

 

The accompanying notes are an integral part of these consolidated financial statements.

 

3



Table of Contents

 

Overstock.com, Inc.

Consolidated Statements of Operations (unaudited)

(in thousands, except per share data)

 

 

 

Three months ended
June 30,

 

Six months ended
June 30,

 

 

 

2007

 

2008

 

2007

 

2008

 

 

 

 

 

 

 

 

 

 

 

Revenue

 

 

 

 

 

 

 

 

 

Direct revenue

 

$

43,578

 

$

39,939

 

$

89,279

 

$

91,422

 

Fulfillment partner revenue

 

105,389

 

148,903

 

217,618

 

298,165

 

 

 

 

 

 

 

 

 

 

 

Total revenue

 

148,967

 

188,842

 

306,897

 

389,587

 

 

 

 

 

 

 

 

 

 

 

Cost of goods sold

 

 

 

 

 

 

 

 

 

Direct(1)

 

36,321

 

34,752

 

75,641

 

79,066

 

Fulfillment partner

 

86,343

 

119,985

 

179,638

 

241,630

 

 

 

 

 

 

 

 

 

 

 

Total cost of goods sold

 

122,664

 

154,737

 

255,279

 

320,696

 

 

 

 

 

 

 

 

 

 

 

Gross profit

 

26,303

 

34,105

 

51,618

 

68,891

 

 

 

 

 

 

 

 

 

 

 

Operating expenses:

 

 

 

 

 

 

 

 

 

Sales and marketing(1)

 

7,962

 

14,244

 

19,246

 

29,263

 

Technology(1)

 

15,237

 

15,311

 

30,210

 

29,827

 

General and administrative(1)

 

10,429

 

10,867

 

21,118

 

20,430

 

Restructuring

 

6,194

 

 

12,283

 

 

 

 

 

 

 

 

 

 

 

 

Total operating expenses

 

39,822

 

40,422

 

82,857

 

79,520

 

 

 

 

 

 

 

 

 

 

 

Operating loss

 

(13,519

)

(6,317

)

(31,239

)

(10,629

)

 

 

 

 

 

 

 

 

 

 

Interest income

 

1,078

 

742

 

2,068

 

2,046

 

Interest expense

 

(1,027

)

(888

)

(2,056

)

(1,789

)

 

 

 

 

 

 

 

 

 

 

Loss from continuing operations

 

(13,468

)

(6,463

)

(31,227

)

(10,372

)

Loss from discontinued operations

 

(300

)

 

(3,924

)

 

 

 

 

 

 

 

 

 

 

 

Net loss

 

$

(13,768

)

$

(6,463

)

$

(35,151

)

$

(10,372

)

 

 

 

 

 

 

 

 

 

 

Net loss per common share — basic and diluted:

 

 

 

 

 

 

 

 

 

Loss from continuing operations

 

$

(0.57

)

$

(0.28

)

$

(1.32

)

$

(0.45

)

Loss from discontinued operations

 

$

(0.01

)

$

 

$

(0.17

)

$

 

Net loss per common share – basic and diluted

 

$

(0.58

)

$

(0.28

)

$

(1.49

)

$

(0.45

)

Weighted average common shares outstanding — basic and diluted

 

23,689

 

22,750

 

23,642

 

23,048

 

 


(1)          Includes stock-based compensation from stock based awards as follows (Note 11):

 

Cost of goods sold — direct

 

$

114

 

$

50

 

$

221

 

$

99

 

Sales and marketing

 

$

85

 

$

86

 

$

163

 

$

170

 

Technology

 

$

188

 

$

220

 

$

365

 

$

434

 

General and administrative

 

$

750

 

$

862

 

$

1,461

 

$

1,849

 

 

The accompanying notes are an integral part of these consolidated financial statements.

 

4



Table of Contents

 

Overstock.com, Inc.

Consolidated Statements of Stockholders’ Equity

and Comprehensive Loss (unaudited)

(in thousands)

 

 

 

Common stock

 

Additional
Paid-in

 

Accumulated

 

Treasury stock

 

Accumulated
Other
Comprehensive

 

 

 

 

 

Shares

 

Amount

 

Capital

 

Deficit

 

Shares

 

Amount

 

Income (loss)

 

Total

 

Balance at December 31, 2007

 

25,423

 

$

2

 

$

333,909

 

$

(243,709

)

(1,605

)

$

(63,278

)

$

(94

)

$

26,830

 

Exercise of stock options

 

73

 

 

924

 

 

 

 

 

924

 

Treasury stock issued for 401(k) matching contribution

 

 

 

(41

)

 

2

 

60

 

 

19

 

Stock-based compensation to employees and directors

 

 

 

2,252

 

 

 

 

 

2,252

 

Stock-based compensation to consultants in exchange for services

 

 

 

315

 

 

 

 

 

315

 

Stock-based compensation for performance share plan

 

 

 

300

 

 

 

 

 

300

 

Purchase of treasury stock

 

 

 

 

 

(1,110

)

(12,000

)

 

(12,000

)

Comprehensive loss:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net loss

 

 

 

 

(10,372

)

 

 

 

(10,372

)

Net unrealized loss on marketable securities

 

 

 

 

 

 

 

(3

)

(3

)

Cumulative translation adjustment

 

 

 

 

 

 

 

(32

)

(32

)

Total comprehensive loss

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

(10,407

)

Balance at June 30, 2008

 

25,496

 

$

2

 

$

337,659

 

$

(254,081

)

(2,713

)

$

(75, 218

)

$

(129

)

$

8,233

 

 

The accompanying notes are an integral part of these consolidated financial statements.

 

5



Table of Contents

 

Overstock.com, Inc.

Consolidated Statements of Cash Flows (unaudited)

(in thousands)

 

 

 

Three months ended

 

Six months ended

 

Twelve months ended

 

 

 

June 30,

 

June 30,

 

June 30,

 

 

 

2007

 

2008

 

2007

 

2008

 

2007

 

2008

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Cash flows from operating activities of continuing operations:

 

 

 

 

 

 

 

 

 

 

 

 

 

Net loss

 

$

(13,768

)

$

(6,463

)

$

(35,151

)

$

(10,372

)

$

(105,268

)

$

(20,236

)

Adjustments to reconcile net loss to cash provided by (used in) operating activities of continuing operations:

 

 

 

 

 

 

 

 

 

 

 

 

 

Loss from discontinued operations

 

300

 

 

3,924

 

 

8,898

 

 

Depreciation and amortization

 

7,974

 

5,887

 

15,745

 

12,384

 

35,046

 

26,134

 

Loss on disposition of property and equipment

 

1

 

 

1

 

 

1

 

 

Stock-based compensation to employees and directors

 

1,137

 

1,068

 

2,210

 

2,252

 

4,284

 

4,564

 

Stock-based compensation to consultants for services

 

135

 

329

 

140

 

315

 

129

 

364

 

Stock-based compensation for performance share plan

 

 

150

 

 

300

 

 

(250

)

Issuance of common stock from treasury for 401(k) matching contribution

 

113

 

 

715

 

19

 

890

 

(202

)

Amortization of debt discount and deferred financing fees

 

86

 

85

 

172

 

172

 

311

 

344

 

Asset impairment and depreciation (other non cash restructuring)

 

2,169

 

 

2,169

 

 

2,960

 

 

Restructuring charges

 

4,025

 

 

10,114

 

 

14,997

 

 

Notes receivable accretion

 

 

(136

)

 

(272

)

 

(544

)

Changes in operating assets and liabilities, net of effect of discontinued operations:

 

 

 

 

 

 

 

 

 

 

 

 

 

Accounts receivable, net

 

(431

)

(2,144

)

3,396

 

(2,882

)

5

 

(7,244

)

Inventories, net

 

1,237

 

3,934

 

4,849

 

11,897

 

53,411

 

1,389

 

Prepaid inventory

 

477

 

(80

)

117

 

924

 

1,119

 

(524

)

Prepaid expenses

 

700

 

(363

)

(1,262

)

(2,909

)

913

 

(1,746

)

Other long-term assets, net

 

176

 

 

266

 

 

744

 

205

 

Accounts payable

 

5,467

 

(1,622

)

(32,592

)

(39,431

)

(2,568

)

(2,327

)

Accrued liabilities

 

4,941

 

428

 

(18,768

)

(10,993

)

(6,033

)

878

 

Deferred revenue

 

200

 

(771

)

654

 

(1,940

)

(427

)

12,130

 

Other long-term liabilities

 

 

147

 

 

(59

)

 

 

(252

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net cash provided by (used in) operating activities of continuing operations

 

14,939

 

449

 

(43,301

)

(40,595

)

9,412

 

12,683

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Cash flows from investing activities of continuing operations:

 

 

 

 

 

 

 

 

 

 

 

 

 

Purchases marketable securities

 

(21,381

)

(18,823

)

(21,381

)

(25,362

)

(21,381

)

(79,198

)

Sales and maturities of marketable securities

 

3,400

 

18,428

 

3,400

 

41,339

 

3,400

 

67,197

 

Expenditures for property and equipment

 

(1,439

)

(5,136

)

(1,916

)

(6,449

)

(13,450

)

(7,176

)

Proceeds from the sale of discontinued operations, net of cash transferred

 

9,892

 

 

9,892

 

 

9,892

 

 

Collection of note receivable

 

753

 

754

 

4,694

 

1,256

 

4,694

 

1,758

 

Decrease in cash resulting from de-consolidation of variable interest entity

 

 

 

 

 

(102

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net cash (used in) provided by investing activities of continuing operations

 

(8,775

)

(4,777

)

(5,311

)

10,784

 

(16,947

)

(17,419

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Cash flows from financing activities of continuing operations:

 

 

 

 

 

 

 

 

 

 

 

 

 

Payments on capital lease obligations

 

(4

)

(2

)

(5,251

)

(3,796

)

(5,454

)

(3,806

)

Drawdown on line of credit

 

 

1,128

 

1,169

 

6,396

 

14,592

 

7,650

 

Payments on line of credit

 

 

(1,128

)

(1,169

)

(6,396

)

(14,592

)

(7,650

)

Issuance of common stock in offerings, net of issuance costs

 

 

 

 

 

39,406

 

 

Purchase of treasury stock

 

 

 

 

(12,000

)

 

(12,000

)

Exercise of stock options

 

768

 

924

 

1,921

 

924

 

2,994

 

2,233

 

Net provided by (used in) financing activities of continuing operations

 

764

 

922

 

(3,330

)

(14,872

)

36,946

 

(13,573

)

 

The accompanying notes are an integral part of these consolidated financial statements.

 

6



Table of Contents

 

Effect of exchange rate changes on cash

 

36

 

(9

)

21

 

(32

)

84

 

(56

)

Cash (used in) provided by operating activities from discontinued operations

 

(614

)

 

(204

)

 

1,307

 

 

Cash used in investing activities of discontinued operations

 

 

 

(53

)

 

(315

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net increase (decrease) in cash and cash equivalents

 

6,350

 

(3,415

)

(52,178

)

(44,715

)

30,487

 

(18,365

)

Change in cash and cash equivalents from discontinued operations

 

614

 

 

257

 

 

(993

)

 

Cash and cash equivalents, beginning of period

 

68,080

 

60,094

 

126,965

 

101,394

 

45,550

 

75,044

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Cash and cash equivalents, end of period

 

$

75,044

 

$

56,679

 

$

75,044

 

$

56,679

 

$

75,044

 

$

56,679

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Supplemental disclosure of cash flow information:

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest paid

 

$

1,585

 

$

1,524

 

$

2,236

 

$

2,163

 

$

4,104

 

$

3,809

 

Asset retirement obligation

 

 

 

 

 

450

 

 

Deemed dividend on redeemable common stock

 

 

 

 

 

33

 

 

Lapse of rescission right on redeemable common stock

 

 

 

 

 

2,431

 

 

Promissory note received in exchange for deconsolidation of variable

 

 

 

 

 

6,702

 

 

Promissory notes received as proceeds from sale of discontinued operations

 

6,000

 

 

6,000

 

 

6,000

 

 

Prior year discretionary 401(k) contribution

 

 

 

 

 

408

 

 

 

The accompanying notes are an integral part of these consolidated financial statements.

 

7



Table of Contents

 

Overstock.com, Inc.

Notes to Unaudited Consolidated Financial Statements

 

1.   BASIS OF PRESENTATION

 

The accompanying unaudited consolidated financial statements have been prepared by Overstock.com, Inc. (the “Company”) pursuant to the rules and regulations of the Securities and Exchange Commission regarding interim financial reporting. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements and should be read in conjunction with Management’s Discussion and Analysis of Financial Condition and Results of Operations and the audited annual consolidated financial statements and related notes thereto included in the Annual Report on Form 10-K for the year ended December 31, 2007. The accompanying unaudited consolidated financial statements reflect all adjustments, consisting of normal recurring adjustments, which are, in the opinion of management, necessary for a fair statement of results for the interim periods presented. Preparing financial statements requires management to make estimates and assumptions that affect the amounts that are reported in the consolidated financial statements and accompanying disclosures. Although these estimates are based on management’s best knowledge of current events and actions that the Company may undertake in the future, actual results may be different from the estimates. The results of operations for the three and six months ended June 30, 2008 are not necessarily indicative of the results to be expected for any future period or the full fiscal year.

 

2.   ACCOUNTING POLICIES

 

Principles of consolidation

 

The accompanying consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. The consolidated financial statements include the accounts of the Company’s OTravel subsidiary through April 25, 2007 (see Note 4—“Sale of Discontinued Operations”).  All significant intercompany account balances and transactions have been eliminated in consolidation.

 

Use of estimates

 

The preparation of financial statements in conformity with generally accepted accounting principles requires estimates and assumptions that affect the reported amounts of assets and liabilities, revenues and expenses, and related disclosures of contingent liabilities in the consolidated financial statements and accompanying notes. Estimates are used for, but not limited to, valuation of investments, receivables valuation, revenue recognition, sales returns, incentive discount offers, inventory valuation, depreciable lives of fixed assets, internally-developed software, valuation of acquired intangibles, income taxes, stock-based compensation, and contingencies. Actual results could differ materially from those estimates.

 

Revenue recognition

 

The Company derives revenue primarily from two sources: direct revenue and fulfillment partner revenue. Direct revenue consists of sale of merchandise to both individual consumers and businesses that are fulfilled directly from the Company’s leased warehouses. Fulfillment partner revenue includes listing fees and commissions collected from products being listed and sold through the Auctions section of its Website, advertisement and lead generation revenue derived from its Cars listing site, and advertising revenue generated by its Real Estate site. The Company has organized its operations into two principal segments based on these primary sources of revenue (see “Note 12 —Business Segments”).

 

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 the Company’s customers. As the Company ships high volumes of packages through multiple carriers, it is not practical for the Company to track the actual delivery date of each shipment. Therefore, the Company uses estimates to determine which shipments are delivered and therefore recognized as revenue at the end of the period. The delivery date estimates are based on average shipping transit times, which are calculated using the following factors: (i) the shipping carrier (as carriers differ in transit times); (ii) the fulfillment source (either the Company’s warehouses or those of its 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.

 

The Company evaluates the criteria outlined in EITF Issue No. 99-19, Reporting Revenue Gross as a Principal Versus Net as an Agent, in determining whether it is appropriate to record the gross amount of product sales and related costs or the net amount earned as commissions. When the Company is the primary obligor in a transaction, is subject to inventory risk, has latitude in establishing prices and selecting suppliers, or has several but not all of these indicators, revenue is recorded gross. If the Company is 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 the Company is the primary obligor.

 

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The Company periodically provides incentive offers to its customers to encourage purchases. Such offers include current discount offers, such as percentage discounts off current purchases and other similar offers. Current discount offers, when accepted by its customers, are treated as a reduction to the purchase price of the related transaction.

 

Direct revenue

 

Direct revenue consists of sales of merchandise to both individual consumers and businesses that are fulfilled directly from the Company’s leased warehouses.  Direct sales occur primarily through the Company’s Website, but may also occur through other offline channels.

 

Fulfillment partner revenue

 

Fulfillment partner revenue consists of merchandise sold through the Company’s Website and shipped by third parties directly to consumers and other businesses from warehouses maintained by the fulfillment partners, as well as revenue from the Auctions, Cars and Real Estate sections of its Website.

 

The auctions site (added to the Website in September 2004) allows sellers to list items for sale, buyers to bid on items of interest, and users to browse through listed items online. With limited exceptions, the Company is not considered the seller of the items sold on the auctions site and has no control over the pricing of those items. Therefore, for these sales, only the listing fees for items listed and commissions for items sold are recorded as revenue during the period items are listed or sold. Auctions revenues were insignificant during the three and six months ended June 30, 2007 and 2008, and are included in the fulfillment partner segment, as they are not large enough to separate out as its own segment.

 

The cars listing service (added to the Website in December 2006) 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 its cars listing business is included in the fulfillment partner segment, as it is not significant enough to separate out as its own segment.

 

The real estate listing service (added to the Website in May 2008) allows customers to search active listings across the country. Listing categories include foreclosures, live and on-line auctions, for sale by owner listings, broker/agent listings and numerous aggregated classified ad listings.  Advertising revenue from the real estate business is included in the fulfillment partner segment, as it is not significant enough to separate out as its own segment.

 

Deferred revenue

 

Payment is generally required by credit card at the point of sale. Amounts received prior to delivery of products or services provided are recorded as deferred revenue. Amounts received in advance for Club O membership fees are recorded as deferred revenue and recognized ratably over the membership period. In addition, the Company sells gift cards and records related deferred revenue at the time of the sale.  Revenue from a gift certificate is recognized when a customer redeems it. If a gift certificate is not redeemed, the Company recognizes revenue when the likelihood of its redemption becomes remote, generally two years from the date of issuance.

 

Internal-Use Software and Website Development

 

The Company includes in fixed assets the capitalized cost of internal-use software and website development, including software used to upgrade and enhance its Website and processes supporting the Company’s business. As required by Statement of Position (“SOP”) 98-1, Accounting for the Costs of Computer Software Developed or Obtained for Internal Use, the Company capitalizes costs incurred during the application development stage of internal-use software and amortizes these costs over the estimated useful life of two to three years. The Company expenses costs incurred related to design or maintenance of internal-use software as incurred.

 

During the three months ended June 30, 2007 and 2008, the Company capitalized $226,000 and $1.8 million, respectively, of costs associated with internal-use software and website development, which are partially offset by amortization of previously capitalized amounts of $3.7 million and $3.1 million for those respective periods.  For the six months ended June 30, 2007 and 2008, the Company capitalized $1.5 million and $2.6 million of costs associated with internal-use software and website development, which are partially offset by amortization of previously capitalized amounts of $7.1 million and $6.2 million, respectively.

 

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Advertising expense

 

The Company recognizes advertising expenses in accordance with SOP 93-7, Reporting on Advertising Costs. As such, the Company expenses the costs of producing advertisements at the time production occurs or the first time the advertising takes place and expenses the cost of communicating advertising in the period during which the advertising space or airtime is used. Internet advertising expenses are recognized as incurred based on the terms of the individual agreements, which are generally: (i) a commission for traffic driven to the Website that generates a sale, and (ii) based on the number of clicks on keywords or links to the Company’s Website generated during a given period. Advertising expense included in sales and marketing expenses totaled $7.1 million and $13.1 million during the three months ended June 30, 2007 and 2008, respectively.  For the six months ended June 30, 2007 and 2008, advertising expenses totaled $17.7 million and $27.0 million, respectively.

 

Restructuring

 

Restructuring expenses are primarily comprised of lease termination costs and the costs incurred for returning leased facilities back to their original condition in anticipation of subleasing current office space. Statement of Financial Accounting Standard (“SFAS”) No. 146, Accounting for Costs Associated with Exit or Disposal Activities (“SFAS No. 146”), requires that when an entity ceases using a property that is leased under an operating lease before the end of its term contract, the termination costs should be recognized and measured at fair value when the entity ceases using the facility. Key assumptions in determining the restructuring expenses include the terms that may be negotiated to exit certain contractual obligations (see Note 3—“Restructuring Expense”).

 

Fair Value of Financial Instruments

 

In September 2006, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 157, Fair Value Measurements (“SFAS No.157”), which defines fair value, establishes guidelines for measuring fair value and expands disclosures regarding fair value measurements. SFAS No. 157 does not require any new fair value measurements but rather eliminates inconsistencies in guidance found in various prior accounting pronouncements. SFAS No. 157 is effective for fiscal years beginning after November 15, 2007. In February 2008, the FASB issued FASB Staff Position, or FSP, FAS No. 157-2, Effective Date of FASB Statement No. 157 (“FSP FAS No. 157-2”), which delayed the effective date of SFAS No. 157 to fiscal years beginning after November 15, 2008 and interim periods within those fiscal years for all non-financial assets and non-financial liabilities, except those that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually). The Company adopted SFAS No. 157 for fiscal 2008, except as it applies to those non-financial assets and non-financial liabilities as described in FSP FAS No. 157-2, and it did not have a material impact on its consolidated financial position, results of operations or cash flows.

 

On a quarterly basis, the Company measures at fair value certain financial assets, including cash equivalents and available-for-sale securities.   SFAS No. 157 specifies a hierarchy of valuation techniques based on whether the inputs to those valuation techniques are observable or unobservable. Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflect the Company’s market assumptions. These two types of inputs have created the following fair-value hierarchy:

 

·

 

Level 1 — Quoted prices for identical instruments in active markets;

 

 

 

·

 

Level 2 — Quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-derived valuations in which all significant inputs and significant value drivers are observable in active markets; and

 

 

 

·

 

Level 3 — Valuations derived from valuation techniques in which one or more significant inputs or significant value drivers are unobservable.

 

This hierarchy requires the Company to minimize the use of unobservable inputs and to use observable market data, if available, when determining fair value. The fair value of these financial assets and liabilities was determined using the following levels of inputs as of June 30, 2008 (in thousands):

 

 

 

Fair Value Measurements as of June 30, 2008:

 

 

 

Total

 

Level 1

 

Level 2

 

Level 3

 

 

 

 

 

 

 

 

 

 

 

Assets:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Cash equivalents — Money market mutual funds

 

$

33,948

 

$

33,948

 

$

 

$

 

Available-for-sale securities

 

30,020

 

30,020

 

 

 

Total assets

 

$

63,968

 

$

63,968

 

$

 

$

 

 

Earnings (loss) per share

 

In accordance with SFAS No. 128, Earnings per share, basic earnings (loss) per share is computed by dividing net income (loss)

 

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attributable to common shares by the weighted average number of common shares outstanding during the period. Diluted earnings (loss) per share is computed by dividing net income (loss) for the period by the weighted average number of common and potential common shares outstanding during the period. Potential common shares, composed of incremental common shares issuable upon the exercise of stock options, restricted stock units, convertible senior notes and shares under the Performance Share Plan, are included in the calculation of diluted net earnings (loss) per share to the extent such shares are dilutive.

 

The following table sets forth the computation of basic and diluted earnings (loss) per share for the periods indicated (in thousands, except per share amounts):

 

 

 

Three months ended June 30,

 

Six months ended June 30,

 

 

 

2007

 

2008

 

2007

 

2008

 

 

 

 

 

 

 

 

 

 

 

Loss from continuing operations

 

$

(13,468

)

$

(6,463

)

$

(31,227

)

$

(10,372

)

Loss from discontinued operations

 

(300

)

 

(3,924

)

 

 

 

 

 

 

 

 

 

 

 

Net loss

 

$

(13,768

)

$

(6,463

)

$

(35,151

)

$

(10,372

)

 

 

 

 

 

 

 

 

 

 

Weighted average common shares outstanding—basic

 

23,689

 

22,750

 

23,642

 

23,048

 

Effective of dilutive securities:

 

 

 

 

 

 

 

 

 

Stock options

 

 

 

 

 

Restricted stock units

 

 

 

 

 

Convertible senior notes

 

 

 

 

 

Shares under the Performance Share Plan

 

 

 

 

 

Weighted average common shares outstanding—diluted

 

23,689

 

22,750

 

23,642

 

23,048

 

Net loss per common share—basic and diluted:

 

 

 

 

 

 

 

 

 

Loss from continuing operations

 

$

(0.57

)

$

(0.28

)

$

(1.32

)

$

(0.45

)

Loss from discontinued operations

 

$

(0.01

)

$

 

$

(0.17

)

$

 

Net loss per common share—basic and diluted

 

$

(0.58

)

$

(0.28

)

$

(1.49

)

$

(0.45

)

 

The stock options, restricted stock units, convertible senior notes outstanding and shares under the Performance Share Plan were not included in the computation of diluted earnings (loss) per share because to do so would have been antidilutive. The number of stock options outstanding at June 30, 2007 and 2008 was 1,290,000 and 1,031,000, respectively.  In the first six months of 2008, the Compensation Committee of the Board of Directors approved grants of approximately 12,000 stock options and 485,000 restricted stock units to officers and employees of the Company.  As of June 30, 2008, there were 457,000 restricted stock units outstanding (see Note 11 – “Stock Based Awards”).  As of June 30, 2008, the Company had $77.0 million of convertible senior notes outstanding, which could potentially convert into 1,010,000 shares of common stock in the aggregate.

 

Recent accounting pronouncements

 

In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities (“SFAS No. 159”). Under SFAS No. 159, companies may elect to measure certain financial instruments and certain other items at fair value. The standard requires that unrealized gains and losses on items for which the fair value option has been elected be reported in earnings. SFAS No. 159 is effective for fiscal years beginning after November 15, 2007. The Company adopted SFAS No. 159 for fiscal 2008; however, it did not elect to apply the fair value option to any financial instruments or other items upon adoption of SFAS No. 159 during the six months ended June 30, 2008. Therefore, the adoption of SFAS No. 159 did not impact the Company’s consolidated financial position, results of operations or cash flows.

 

In December 2007, the FASB issued SFAS No. 141 (R), Business Combinations (“SFAS No. 141 (R)”), and SFAS No. 160, Noncontrolling Interests in Consolidated Financial Statements (“SFAS No. 160”). SFAS No. 141 (R) requires an acquirer to measure the identifiable assets acquired, the liabilities assumed and any noncontrolling interest in the acquired entity at their fair values on the acquisition date, with goodwill being the excess value over the net identifiable assets acquired. SFAS No. 160 clarifies that a noncontrolling interest in a subsidiary should be reported as equity in the consolidated financial statements. The calculation of earnings per share will continue to be based on income amounts attributable to the parent. SFAS No. 141 (R) and SFAS No. 160 are effective for financial statements issued for fiscal years beginning after December 15, 2008. Early adoption is prohibited.  The Company does not expect the adoption of  SFAS No. 141 (R) or SFAS No. 160 to impact its financial position and results of operations or cash flows.

 

In March 2008, the FASB issued SFAS No. 161, Disclosures about Derivative Instruments and Hedging Activities – an amendment of FASB Statement No. 133 (“SFAS No. 161”).  SFAS No. 161 requires enhanced disclosures about a company’s derivative and hedging activities, in particular: 1) how and why derivative instruments are utilized; 2) how derivative instruments and related hedged items are accounted for under SFAS No. 133 and its related interpretations; and 3) how derivative instruments and

 

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related hedged items affect a company’s financial position, financial performance and cash flows. SFAS No. 161 is effective for financial statements issued for fiscal years and interim periods beginning after November 15, 2008, with early adoption encouraged. The Company has no derivative instruments.  Therefore, the Company does not expect the adoption of SFAS No. 161 to impact its financial position and results of operations or cash flows.

 

In May 2008, the FASB issued SFAS No. 162, The Hierarchy of Generally Accepted Accounting Principles (“SFAS No. 162”). The current GAAP hierarchy was established by the American Institute of Certified Public Accountants, and faced criticism because it was directed to auditors rather than entities. The issuance of this statement corrects this and makes some other hierarchy changes. This statement is effective 60 days following the Securities and Exchange Commission’s approval of the Public Company Accounting Oversight Board amendments to AU Section 411, The Meaning of Present Fairly in Conformity with Generally Accepted Accounting Principles.  The FASB does not expect that this statement will result in a change to current practice.

 

3.   RESTRUCTURING EXPENSE

 

During the fourth quarter of 2006, the Company began a facilities consolidation and restructuring program designed to reduce its overall expense structure in an effort to improve future operating performance, and incurred $5.7 million of restructuring charges related to the early termination of a data center lease.

 

During fiscal year 2007, the Company recorded $12.3 million of restructuring charges, of which $9.9 million related to the termination of a logistics services agreement, termination and settlement of a lease related to vacated warehouse facilities in Indiana, and abandonment and marketing for sub-lease office and data center space in the Company’s current corporate office facilities. The Company also recorded an additional $2.2 million of restructuring charges related to accelerated depreciation of leasehold improvements located in the abandoned office and co-location data center space and $200,000 of other miscellaneous restructuring charges.

 

Restructuring liabilities along with charges to expense, cash payments or accelerated depreciation of leasehold improvements associated with the facilities consolidation and restructuring program were as follows (in thousands):

 

 

 

Balance
12/31/2007

 

Charges to
Expense

 

Cash
payment

 

Balance
06/30/2008

 

Lease and contract termination costs

 

$

4,035

 

$

 

$

(555

)

$

3,480

 

Total

 

$

4,035

 

$

 

$

(555

)

$

3,480

 

 

Of the $3.5 million of restructuring liabilities, $3.0 million is classified in the balance sheet as “Other long-term liabilities” with the remainder in accrued liabilities.

 

Under the restructuring program, the Company recorded $18.0 million in restructuring charges through the end of the second quarter of 2007, including $5.7 million in fiscal year 2006 and $12.3 million in fiscal year 2007. There were no restructuring charges during the six months ended June 30, 2008.  The costs incurred to date within each restructuring category approximate the costs that the Company had anticipated at the beginning of the program. In 2009, the Company intends to move its corporate office facilities into new warehouse space leased on April 8, 2008 (see Note 8 – “Commitments and Contingencies”).  The Company believes that, except for the additional lease and contract termination costs related to relocating its current office facilities to the new warehouse location, the restructuring program is substantially complete.

 

4.   SALE OF DISCONTINUED OPERATIONS

 

On July 1, 2005, the Company acquired all the outstanding capital stock of Ski West, Inc. (“Ski West”) for an aggregate of $25.1 million (including $111,000 of capitalized acquisition related expenses).

 

Ski West was an on-line travel company whose proprietary technology provides consumer access to a large, fragmented, hard-to-find inventory of lodging, vacation, cruise and transportation bargains, primarily in popular ski areas in the U.S. and Canada. Effective upon the closing, Ski West became a wholly-owned subsidiary of the Company, and the Company integrated the Ski West travel offerings with the Company’s existing travel offerings and changed its name to OTravel.com, Inc (“OTravel”).

 

During the fourth quarter of 2006, in conjunction with the facilities consolidation and restructuring program described in Note 3, management decided to sell OTravel.  The Company evaluated its plan to sell OTravel in accordance with SFAS No. 144, Accounting for the Impairment of Long-Lived Assets (“SFAS No. 144”), which requires that long-lived assets be classified as held for sale only when certain criteria are met.  The Company classified the OTravel assets and liabilities as “held for sale” as it met these criteria as of December 31, 2006, which included: management’s commitment to a plan to sell the assets; availability of the assets for immediate sale in their present condition; an active program to locate buyers and other actions to sell the assets has been initiated; sale of the assets is probable and their transfer is expected to qualify for recognition as a completed sale within one year; assets are being

 

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marketed at reasonable prices in relation to their fair value; and the unlikelihood  that significant changes will be made to the plan. The travel business was not part of the Company’s core business operations and was no longer part of its strategic focus. The results of operations for the subsidiary were included in the fulfillment partner segment prior to being classified as discontinued operations.

 

The Company also determined that the OTravel subsidiary met the definition of a “component of an entity” and accounted for it as a discontinued operation under SFAS No. 144.  The results of operations for this subsidiary have been classified as discontinued operations in all periods presented.  In conjunction with the discontinuance of OTravel, the Company performed an evaluation of the goodwill associated with the reporting unit pursuant to SFAS No. 142, Goodwill and Other Intangible Assets (“SFAS No. 142”) and SFAS No. 144 and determined that goodwill of approximately $4.5 million was impaired as of December 31, 2006, based on a non-binding letter of intent from a third party to purchase the business.  During the quarter ended June 30, 2007, the Company received a revised offer from this third party to purchase its OTravel business and, in April 2007, the Company completed the sale of OTravel under these revised terms.  Accordingly, the Company evaluated its goodwill as of June 30, 2007 and, based on the estimated fair value of the discounted cash flows of the net proceeds from the sale, determined that an additional $3.8 million of goodwill was impaired.

 

On April 25, 2007, the Company completed the sale of OTravel.com to Castles Travel, Inc., an affiliate of Kinderhook Industries, LLC, and Castles Media Company LLC, for $17.0 million.  The Company received cash proceeds, net of cash transferred, of $9.9 million and two $3.0 million promissory notes.  The $3.0 million senior note matures three years from the closing date and bears interest, payable quarterly, of 4.0%, 10.0% and 14.0% per year in the first, second and third years, respectively.  The $3.0 million junior note matures five years from the closing date and bears interest of 8.0% per year, compounded annually, and is payable in full at maturity.

 

The following table is a summary of the Company’s discontinued operations for the quarter-to-date period ended April 25, 2007 and the year-to-date period ended April 25, 2007 (in thousands):

 

 

 

Quarter-to-date
period ended
April 25,
2007

 

Year-to-date
period ended
April 25,
2007

 

Sales

 

$

145

 

$

2,226

 

Cost of sales

 

(78

)

(650

)

Gross profit

 

67

 

1,576

 

Sales and marketing

 

(105

)

(447

)

Technology

 

(16

)

(60

)

General and administrative

 

(246

)

(1,152

)

Goodwill impairment

 

 

(3,841

)

Loss from discontinued operations

 

$

(300

)

$

(3,924

)

 

5.   MARKETABLE SECURITIES

 

The Company’s marketable securities are reported at fair value with the related unrealized gains and losses included in accumulated other comprehensive income (loss), a component of shareholders’ equity, net of any tax effect. Realized gains or losses on the sale of marketable securities are determined using the specific-identification method.

 

The Company evaluates its investments periodically for possible other-than-temporary impairment by reviewing factors such as the length of time and extent to which fair value has been below cost basis, the financial condition of the issuer and the Company’s ability and intent to hold the investment for a period of time which may be sufficient for anticipated recovery of market value. The Company records an impairment charge to the extent that the carrying value of its available-for-sale securities exceeds the estimated fair market value of the securities and the decline in value is determined to be other-than-temporary. The Company did not record any impairment charges related to other-than-temporary decline in value of its marketable securities during the three or six months ended June 30, 2007 or 2008.

 

As of June 30, 2008, the Company’s marketable securities consisted of U.S. agency securities, commercial paper, and AAA-rated asset-backed securities collateralized by automobile loans/leases or credit card receivables. All marketable securities are classified as available-for-sale securities. The following table summarizes the Company’s marketable security investments as of June 30, 2008 (in thousands):

 

 

 

Cost

 

Net Unrealized
Gains (Losses)

 

Estimated Fair
Market Value

 

Marketable securities:

 

 

 

 

 

 

 

U.S. Agency Securities

 

$

16,747

 

$

5

 

$

16,752

 

Commercial Paper

 

10,455

 

1

 

10,456

 

Asset-Backed Securities

 

2,821

 

(9

)

2,812

 

 

 

 

 

 

 

 

 

Total available-for-sale investments

 

$

30,023

 

$

(3

)

$

30,020

 

 

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There were no realized gains and losses on sales of marketable securities during the three and six months ended June 30, 2007 and 2008.

 

6.   OTHER COMPREHENSIVE LOSS

 

The Company follows SFAS No. 130, Reporting Comprehensive Income. This Statement establishes requirements for reporting comprehensive income (loss) and its components. The Company’s comprehensive loss is as follows (in thousands):

 

 

 

Three months ended June 30,

 

Six months ended June 30,

 

 

 

2007

 

2008

 

2007

 

2008

 

 

 

 

 

 

 

 

 

 

 

Net loss

 

$

(13,768

)

$

(6,463

)

$

(35,151

)

$

(10,372

)

Net unrealized gain (loss) on marketable securities

 

1

 

(125

)

1

 

(3

)

Foreign currency translation adjustment

 

36

 

(9

)

21

 

(32

)

 

 

 

 

 

 

 

 

 

 

Comprehensive loss

 

$

(13,731

)

$

(6,597

)

$

(35,129

)

$

(10,407

)

 

7.   BORROWINGS

 

Wells Fargo Operational Credit Agreement

 

The Company has a credit agreement (as amended to date, the “Credit Agreement”) with Wells Fargo Bank, National Association (“Wells Fargo”). The Credit Agreement provides a revolving line of credit to the Company of up to $30.0 million which the Company uses primarily to obtain letters of credit to support operations, namely, inventory purchases. Interest on borrowings is payable monthly and accrued at either (i) 1.0% above LIBOR in effect on the first day of an applicable fixed rate term, or (ii) at a fluctuating rate per annum determined by the bank to be one half a percent (0.50%) above daily LIBOR in effect on each business day a change in daily LIBOR is announced by the bank. The Credit Agreement expires on January 1, 2010, and requires the Company to comply with certain covenants, including restrictions on mergers, business combinations or transfer of assets.

 

Borrowings and outstanding letters of credit under the Credit Agreement are required to be completely collateralized by cash balances held at Wells Fargo Bank, N.A, and therefore the facility does not provide additional liquidity to the Company.

 

At June 30, 2008, no amounts were outstanding under the Credit Agreement, and letters of credit totaling $2.5 million were issued on behalf of the Company.

 

Wells Fargo Retail Finance Agreement

 

The Company is a party to a Loan and Security Agreement (the “WFRF Agreement”) with Wells Fargo Retail Finance, LLC and related security agreements and other agreements described in the WFRF Agreement.

 

The WFRF Agreement provides for advances to the Company and for the issuance of letters of credit for its account of up to an aggregate maximum of $40.0 million. The amount actually available to the Company may be less and may vary from time to time, depending on, among other factors, the amount of its eligible inventory and receivables. The Company’s obligations under the WFRF Agreement and all related agreements are collateralized by all or substantially all of the Company’s and its subsidiaries’ assets. The Company’s obligations under the WFRF Agreement are cross-collateralized with its assets pledged under its $30.0 million credit facility with Wells Fargo Bank, N.A. The WFRF Agreement contains standard default provisions and expires on December 12, 2008. The conditions to the Company’s use of the facility include a 45-day advance notice requirement.

 

Advances under the WFRF Agreement bear interest at either (i) the rate announced, from time to time, within Wells Fargo Bank, N.A. at its principal office in San Francisco as its “prime rate” or (ii) a rate based on LIBOR plus a varying percentage between 1.25% and 1.75%; however, the annual interest rate on advances under the WFRF Agreement will be at least 3.50%. The WFRF Agreement includes affirmative covenants as well as negative covenants that prohibit a variety of actions without the lender’s approval, including covenants that limit the Company’s ability to (a) incur or guarantee debt, (b) create liens, (c) enter into any merger, recapitalization or similar transaction or purchase all or substantially all of the assets or stock of another person, (d) sell assets, (e) change its name or the name of any of its subsidiaries, (f) make certain changes to its business, (g) optionally prepay, acquire or refinance indebtedness, (h) consign inventory, (i) pay dividends on, or purchase, acquire or redeem shares of, its capital stock,

 

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(j) change its method of accounting, (k) make investments, (l) enter into transactions with affiliates, or (m) store any of its inventory or equipment with third parties. At June 30, 2008, no amounts were outstanding and availability under the WFRF Agreement was $8.4 million.

 

Wells Fargo Commercial Card  Agreement

 

The Company has a commercial card agreement (the “Commercial Card”) with Wells Fargo Bank, National Association (“Wells Fargo”).  The Company uses the Commercial Card primarily for business purpose purchasing and must be paid in full each month.  Outstanding amounts under the Commercial Card are collateralized by cash balances held at Wells Fargo Bank, N.A, and therefore the facility does not provide additional liquidity to the Company.  At June 30, 2008, $1.5 million was outstanding and availability under the Commercial Card was $3.5 million.

 

Capital leases

 

The Company leased certain software and computer equipment under one non-cancelable capital lease that expired in June 2008.

 

Software and equipment relating to expired capital leases totaled $19.8 million at June 30, 2007 and 2008, with accumulated depreciation of $13.4 million and $18.5 million at those respective dates. Depreciation of assets recorded under expired capital leases was $1.4 million and $1.0 million during the three months ended June 30, 2007 and 2008, respectively.  For the six months ended June 30, 2007 and 2008, depreciation of assets recorded under capital leases was $2.9 million and $2.4 million, respectively. As of June 30, 2008, the Company has no remaining capital leases.

 

3.75% Convertible senior notes

 

In November 2004, the Company completed an offering of $120.0 million of 3.75% Convertible Senior Notes (the “Senior Notes”). Proceeds to the Company were $116.2 million, net of $3.8 million of initial purchaser’s discount and debt issuance costs. The discount and debt issuance costs are being amortized using the straight-line method which approximates the interest method. The Company recorded amortization of discount and debt issuance costs related to this offering totaling $86,000 and $85,000 during the three months ended June 30, 2007 and 2008, respectively. For the six months ended June 30, 2007 and 2008, amortization of discount and debt issuance costs totaled $172,000 for both periods.  Interest on the Senior Notes is payable semi-annually on June 1 and December 1 of each year. The Senior Notes mature on December 1, 2011 and are unsecured and rank equally in right of payment with all existing and future unsecured, unsubordinated debt and senior in right of payment to any existing and future subordinated indebtedness.

 

The Senior Notes are convertible at any time prior to maturity into the Company’s common stock at the option of the note holders at a conversion price of $76.23 per share or, approximately 1,010,000 shares in aggregate (subject to adjustment in certain events, including stock splits, dividends and other distributions and certain repurchases of the Company’s stock, as well as certain fundamental changes in the ownership of the Company). Beginning December 1, 2009, the Company has the right to redeem the Senior Notes, in whole or in part, for cash at 100% of the principal amount plus accrued and unpaid interest. Upon the occurrence of a fundamental change (including the acquisition of a majority interest in the Company, certain changes in the Company’s board of directors or the termination of trading of the Company’s stock) meeting certain conditions, holders of the Senior Notes may require the Company to repurchase for cash all or part of their notes at 100% of the principal amount plus accrued and unpaid interest.

 

The indenture governing the Senior Notes requires the Company to comply with certain affirmative covenants, including making principal and interest payments when due, maintaining the Company’s corporate existence and properties, and paying taxes and other claims in a timely manner.

 

At June 30, 2008, $77.0 million of the Senior Notes remained outstanding.

 

8.   COMMITMENTS AND CONTINGENCIES

 

Commitments

 

Corporate office space

 

Through July 2005, the Company leased 43,000 square feet of office space at Old Mill Corporate Center I for its principal corporate offices under an operating lease which was originally scheduled to expire in January 2007. Beginning July 2005, this lease was terminated and replaced with a lease for approximately 154,000 rentable square feet in the Old Mill Corporate Center III in Salt Lake City, Utah for a term of ten years. The total lease obligation over the remaining term of this lease is $31.4 million, of which approximately $3.9 million is payable in the next twelve months.  $8.2 million of the total lease obligation is offset by estimated

 

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sublease payments, of which $1.2 million is anticipated to be received in the next twelve months.

 

In 2006, the Company commenced implementation of a facilities consolidation and restructuring program. Under the program, the Company recorded $638,000 of accelerated amortization of leasehold improvements related to its current office facilities that it is attempting to sublease, and $450,000 of costs incurred to return its office facilities to their original condition as required by the lease agreement.

 

During fiscal year 2007, the Company recorded an additional $6.2 million of restructuring costs related to its marketing for sub-lease office and data center space in its current corporate office facilities. The Company also recorded an additional $2.2 million of restructuring charges related to accelerated depreciation of leasehold improvements located in the abandoned office and co-location data center space and $200,000 of other miscellaneous restructuring charges (see Note 3—“Restructuring Expense”).

 

Logistics and warehouse space

 

In July 2004, the Company entered into a logistics service agreement (the “Logistics Agreement”) wherein the handling, storage and distribution of some of its prepackaged products were performed by a third party. The Logistics Agreement and subsequent amendment set forth terms on which the Company paid various fixed fees based on square feet of storage and various variable costs based on product handling costs for a term of five years.

 

In December 2005, the Company entered into a warehouse facilities lease agreement (the “License Agreement”) to license approximately 400,000 square feet of warehouse space in Indiana. The License Agreement was subsequently amended, reducing the amount of lease space to approximately 300,000 square feet and extending the term to 2011.

 

In the first quarter of 2007, the Company terminated the Logistics Agreement and gave notice of intent to sublease the Indiana warehouse facilities under the License Agreement. During the second quarter of 2007, the Company reached an agreement to terminate the Indiana warehouse facilities lease effective August 15, 2007. As a result of the termination of the License agreement and warehouse lease, the Company incurred $3.7 million of related restructuring charges in 2007 (see Note 3 —“Restructuring Expense”).

 

The Company currently leases 640,000 square feet for its warehouse facilities in Utah under operating leases which expire in August 2012.

 

On April, 8, 2008, the Company entered into a lease agreement with Natomas Meadows, LLC (“Natomas Lease”).  The Natomas Lease is for a 686,865 square foot warehouse facility, now under construction in Salt Lake City, Utah (“New Warehouse”).  The Natomas Lease provides that the Company will lease the New Warehouse in stages: beginning September 1, 2008, the Company will lease a total of 232,900 square feet of the New Warehouse; on February 1, 2009, the Company will lease a total of 435,400 square feet; and, on September 1, 2009, the Company will lease the remainder, for a total of 686,865 square feet.  The Natomas Lease term is seven years, and specifies rent, exclusive of common area maintenance fees, at a variable rate over the course of the staged Lease term, ranging from $0.3300 per square foot for the first stage, to $0.3950 per square foot for the last year of the Natomas Lease term.   The Company currently has warehouse operations in three facilities in Salt Lake City.  Over the course of the staged Natomas Lease, the Company plans to consolidate to the New Warehouse its warehouse operations from two of its smaller leased warehouse facilities in Salt Lake City.  Both of these smaller warehouse facilities are under common ownership with Natomas Meadows, LLC. The common owner has agreed to cancel the Company’s leases of those facilities without any early termination penalty.  The Natomas Lease anticipates that the Company may construct a corporate office facility within the New Warehouse.  The Company intends to expand its customer service operations into the New Warehouse in 2008, and to move its corporate office facility to the New Warehouse in 2009.

 

Co-location data center

 

In July 2005, the Company entered into a Co-location Center Agreement (the “Co-location Agreement”) to build out and lease 11,289 square feet of space at Old Mill Corporate Center II for an IT co-location data center. The Co-location Agreement set forth the terms on which the Lessor would incur the costs to build out the IT co-location data center and the Company would commence to lease the space upon its completion for a term of ten years. In November 2006 however, the Company made the determination to consolidate its facilities and to not occupy the IT co-location data center, and the Co-location Agreement was terminated effective December 29, 2006, for which the Company incurred a $4.6 million restructuring charge (see Note 3—“Restructuring Expense”).

 

In December 2006, the Company entered into a Data Center Agreement (the “OM I Agreement”) to lease 3,999 square feet of space at Old Mill Corporate Center I for an IT data center to allow the Company to consolidate other IT data center facilities.

 

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Computer equipment operating leases

 

The Company has two operating leases for certain computer equipment that expire in the first and fourth quarters of 2010. It is expected that such leases will be renewed by exercising purchase options or replaced by leases of other computer equipment.

 

Summary of future minimum lease payments for all operating leases

 

Minimum future payments under all operating leases described above are as follows (in thousands):

 

Payments due by period

 

 

 

2008

 

$

8,154

 

2009

 

8,480

 

2010

 

8,859

 

2011

 

9,148

 

2012

 

8,395

 

Thereafter

 

18,993

 

 

 

$

62,029

 

 

Rental expense for operating leases totaled $3.5 million and $2.9 million for the three months ended June 30, 2007 and 2008, respectively.  For the six months ended June 30, 2007 and 2008, rental expense totaled $7.4 million and $5.9 million, respectively.

 

Legal Proceedings

 

From time to time, the Company receives claims of and becomes subject to consumer protection, employment, intellectual property and other commercial litigation related to the conduct of the Company’s business. Such litigation could be costly and time consuming and could divert its management and key personnel from its business operations. The uncertainty of litigation increases these risks. In connection with such litigation, the Company may be subject to significant damages or equitable remedies relating to the operation of its business and the sale of products on the Company’s website. Any such litigation may materially harm its business, prospects, results of operations, financial condition or cash flows. However, the Company does not currently believe that any of its outstanding litigation will have a material adverse effect on its financial statements.

 

On August 11, 2005, along with a shareholder plaintiff, the Company filed a complaint against Gradient Analytics, Inc.; Rocker Partners, LP; Rocker Management, LLC; Rocker Offshore Management Company, Inc. and their respective principals in the Superior Court of California, County of Marin. On October 12, 2005, the Company filed an amended complaint against the same entities alleging libel, intentional interference with prospective economic advantage and violations of California’s unfair business practices act. On March 7, 2006, the court denied the defendants demurrers to and motions to strike the amended complaint. The defendants each filed a motion to appeal the court’s decision, the Company responded and the California Attorney General submitted an amicus brief supporting the Company’s view; the court has ruled that this appeal stays discovery in the case. On May 30, 2007 the California Court of Appeals upheld the lower court’s ruling in the Company’s favor. Defendants filed motions for rehearing, which the Court of Appeals summarily denied on June 27, 2007. Defendants filed Petitions for Review before the California Supreme Court which the California Supreme court denied on September 19, 2007. On October 1, 2007, the Court of Appeals remitted the case back to the Superior Court. On December 4, 2007, Matthew Kliber, a former principal of Gradient Analytics, filed a motion for judgment on the pleading which the court denied on February 8, 2008. The parties have begun discovery in this case. The Company intends to continue to pursue this action vigorously. The court has set an April 27, 2009 trial date.

 

On November 9, 2007, Copper River Partners, L.P. (formerly known as Rocker Partners, LP) filed a cross-complaint against the Company and certain of its current and former directors. The Copper River cross-complaint alleges cross-defendants have engaged in violations of California’s state securities laws, violations of California’s unfair business practices act, tortuous interference with contract and prospective business advantage, and deceit. In January 2008, each of the cross-defendants filed various motions in opposition of this cross-complaint. On April 23, 2008, the court dismissed Copper River’s cross claims against former Company directors, John Byrne and Jason Lindsey, and current Company director Allison Abraham.  In that same ruling, the court dismissed four of the six claims against former Company director John Fisher: securities fraud, unfair business practices, common law fraud and equitable indemnity.  In a separate ruling on the same day relating to the Company and Patrick Byrne, the court dismissed the common law fraud claims and equitable indemnity claims and eliminated the possibility of money damages under Copper River’s claims that Overstock and Byrne engaged in unfair business practices.  In other portions of the court’s rulings, the court declined to dismiss Copper River’s securities fraud claims and its request for an injunction for unfair business practices against the Company and Patrick Byrne and the claims for tortious interference with contract and prospective business advantage against the Company, Patrick Byrne and John Fisher. On June 20, Copper River dismissed its complaints against Mr. Fisher. The parties have begun discovery in this case. The Company intends to defend the Copper River cross-complaint vigorously.

 

On January 30, 2008, Gradient Analytics, Inc. filed a motion for leave to file a cross-complaint against the Company and Patrick Byrne. Neither the Company nor Patrick Byrne opposed this motion.  On April 14, 2008 the court granted this motion and Gradient

 

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Analytics filed a cross-complaint against the Company and Patrick Byrne. The Gradient Analytics cross-complaint alleges that the Company and Dr. Byrne engaged in violations of California’s unfair business practices act, interference with prospective business advantage, and libel. On July 9, 2008, the court dismissed three of Gradient Analytics’ claims against Dr. Byrne based on statute of limitations grounds (but allowed for Gradient to amend its complaint) and restricted Gradient Analytics’ claim for unfair business practices, disallowing the possibility of money damages on that claim, and limiting it only to possible injunctive relief if Gradient Analytics proves the claim at trial.  On July 25, 2008, Gradient Analytics filed a First Amended Cross-Complaint again alleging that the Company and Dr. Byrne engaged in violations of California’s unfair business practices act, interference with prospective business advantage, and libel. The parties have begun discovery in this case. The Company intends to defend the Gradient Analytics cross-complaint vigorously.

 

On May 9, 2006 the Company received a notice of an investigation and subpoena from the Securities and Exchange Commission, Salt Lake City District Office. On May 17, 2006, Patrick Byrne also received a subpoena from the Securities and Exchange Commission, Salt Lake City District Office. These subpoenas requested a broad range of documents, including, among other documents, all documents relating to the Company’s accounting policies, the Company’s targets, projections or estimates related to financial performance, the Company’s recent restatement of its financial statements, the filing of its complaint against Gradient Analytics, Inc., the development and implementation of certain new technology systems and disclosures of progress and problems with those systems, communications with and regarding investment analysts, communications regarding shareholders who did not receive the Company’s proxy statement in April 2006, communications with certain shareholders, and communications regarding short selling, naked short selling, purchases and sales of Company stock, obtaining paper certificates, and stock loan or borrow of Company shares. The Company and Dr. Byrne responded to these subpoenas and cooperated with the Securities and Exchange Commission on this matter.  On June 6, 2008, the Regional Director of the Salt Lake District Office of the Securities and Exchange Commission informed the Company that the office had completed its investigation of the Company and its officers and did not intend to recommend any enforcement action by the Securities and Exchange Commission against the Company or its officers.

 

On February 2, 2007, along with five shareholder plaintiffs, the Company filed a lawsuit in the Superior Court of California, County of San Francisco against Morgan Stanley & Co. Incorporated, Goldman Sachs & Co., Bear Stearns Companies, Inc., Bank of America Securities LLC, Bank of New York, Citigroup Inc., Credit Suisse (USA) Inc., Deutsche Bank Securities, Inc., Merrill Lynch, Pierce, Fenner & Smith, Inc., and UBS Financial Services, Inc. In September 2007, the Company filed an amended complaint adding two plaintiff shareholders, naming Lehman Brothers Holdings Inc. as a defendant, eliminating the previous claim of intentional interference with prospective economic advantage and clarifying various points of other claims in the original complaint. The suit alleges that the defendants, who control over 80% of the prime brokerage market, participated in an illegal stock market manipulation scheme and that the defendants had no intention of covering short sell orders with borrowed stock, as they are required to do, causing what are referred to as “fails to deliver” and that the defendants’ actions caused and continue to cause dramatic distortions with in the nature and amount of trading in the Company’s stock as well as dramatic declines in the share price of the Company’s stock. The suit asserts that a persistent large number of “fails to deliver” creates significant downward pressure on the price of a company’s stock and that the amount of “fails to deliver” has exceeded the Company’s entire supply of outstanding shares. The suit accuses the defendants of violations of California securities laws and common law, specifically, conversion, trespass to chattels, intentional interference with prospective economic advantage, and violations of California’s Unfair Business Practices Act. The Company is seeking damages of $3.48 billion. In April 2007 defendants filed a demurrer and motion to strike the Company’s complaint. The Company opposed the demurrer and motion to strike. In July 2007 the court substantially denied defendants’ demurrer and motion to strike. In November 2007, the defendants filed additional motions to strike. In February 2008, the court denied defendants’ motion to strike the Company’s claims under California’s Securities Anti-Fraud statute and defendants’ motion to strike the Company’s common law punitive damages claims, but granted in part the defendants’ motion to strike Overstock’s claims under California’s Unfair Business Practices Act, while allowing the Company’s claims for injunctive relief under California’s Unfair Business Practices Act. The parties have begun discovery in this case. The Company intends to vigorously prosecute this action.

 

On March 29, 2007, the Company, along with other defendants, was sued in United States District Court for the Eastern District of Texas, Tyler Division, by Orion IP, LLC. The suit alleged that the Company and the other defendants infringe two patents owned by Orion that relate to the making and using supply chain methods, sales methods, sales systems, marketing methods, marketing systems, and inventory systems. On April 30, 2007, the Company filed an answer denying Orion’s allegations and a counterclaim asserting that Orion’s patent is invalid. The parties have reached a confidential agreement that settled the case and the case was dismissed on June 11, 2008.

 

On April 15, 2008, the Company received a letter from the Office of the District Attorney of Marin County, California, stating that the District Attorneys of Marin and four other counties in Northern California have begun an investigation into the way the Company advertises products for sale, together with an administrative subpoena seeking related information and documents.  The subpoena requests a range of documents, including documents relating to pricing methodologies, definitions of core and partner product, as well as other site-defined terms, and the methods of internal and external pricing of products, as well as documents related to the pricing of a list of product items identified in the subpoena.  The Company believes that it follows industry advertising practices and intends to cooperate with the investigation.

 

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On May 30, 2008 the Company filed a complaint in New York state court against the New York State Department of Taxation and Finance, its Commissioner, the State of New York and its governor, alleging that a recently enacted New York state tax law is unconstitutional. The effect of the New York law is to require internet sellers to collect and remit New York sales taxes on their New York sales, even though the seller has no New York tax “nexus” other than with New York based independent contractors who are internet advertising affiliates. The complaint asks for the court to declare the law unconstitutional and enjoin its application to the Company.  New York has not answered the complaint, and the case is in its early phase.

 

On June 6, 2008, the Company along with other defendants was sued in the United States District Court for the Eastern District of Texas, Marshall Division, by Transauction, LLC.  The suit alleges the Company and other defendants infringe on a patent owned by Transauction. The patent concerns processes by which an internet auction seller may become bonded for an internet auction sales transaction.  The Company has not yet answered the Complaint.  The Company intends to vigorously defend this action.

 

9.   INDEMNIFICATIONS AND GUARANTEES

 

During its normal course of business, the Company has made certain indemnities, commitments, and guarantees under which it may be required to make payments in relation to certain transactions. These indemnities include, but are not limited to, indemnities to various lessors in connection with facility leases for certain claims arising from such facility or lease, and indemnities to directors and officers of the Company to the maximum extent permitted under the laws of the State of Delaware. The duration of these indemnities, commitments, and guarantees varies, and in certain cases, is indefinite. In addition, the majority of these indemnities, commitments, and guarantees do not provide for any limitation of the maximum potential future payments the Company could be obligated to make. As such, the Company is unable to estimate with any reasonableness its potential exposure under these items. The Company has not recorded any liability for these indemnities, commitments, and guarantees in the accompanying consolidated balance sheets. The Company does, however, accrue for losses for any known contingent liability, including those that may arise from indemnification provisions, when future payment is both probable and reasonably estimable. The Company carries specific and general liability insurance policies that the Company believes would, in most circumstances, provide some, if not total recourse to any claims arising from these indemnifications.

 

10. STOCK REPURCHASE PROGRAM

 

On January 14, 2008, the Company’s Board of Directors authorized a repurchase program that allows the Company to purchase up to $20.0 million of its common stock and / or its 3.75% Senior Convertible Senior Notes due 2011 through December 31, 2009. Under this repurchase program, the Company repurchased approximately 1.1 million shares of its common stock in open market purchases for $12.0 million during the six months ended June 30, 2008.  During July 2008, the Company repurchased an additional 30,000 shares of its common stock in open market purchases for approximately $482,000.

 

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11. STOCK BASED AWARDS

 

The Company has equity incentive plans that provide for the grant to employees of stock-based awards, including stock options, restricted stock units and performance shares awards.

 

Stock-based compensation expense recognized under SFAS No. 123(R), Share-Based Payment (“SFAS No.123(R)”) for the three and six months ended June 30, 2007 and 2008 were as follows (in thousands):

 

 

 

Three months ended June 30,

 

Six months ended June 30,

 

 

 

2007

 

2008

 

2007

 

2008

 

 

 

 

 

 

 

 

 

 

 

Stock options

 

$

1,137

 

$

826

 

$

2,210

 

$

1,760

 

Restricted stock units

 

 

242

 

 

492

 

Performance shares

 

 

150

 

 

300

 

 

 

 

 

 

 

 

 

 

 

Total stock-based compensation expense

 

$

1,137

 

$

1,218

 

$

2,210

 

$

2,552

 

 

Stock Options

 

The exercise price of each stock option granted under the Company’s employee equity incentive plans is equal to or greater than the market price of its common stock on the date of grant. Generally, option grants vest over four years, expire no later than ten years from the grant date and are subject to the employee’s continuing service to the Company.  The fair value of each option grant is estimated on the date of grant using the Black-Scholes-Merton (“BSM”) option pricing model. The weighted average grant date fair value of options granted and the weighted average assumptions used in the model for the three and six months ended June 30, 2007 and June 30, 2008 were as follows:

 

 

 

Three Months Ended

 

Six Months Ended

 

 

 

June 30,

 

June 30.

 

 

 

2007

 

2008

 

2007

 

2008

 

Dividend yield

 

None

 

None

 

None

 

None

 

Expected volatility

 

64.3

%

65.9

%

65.3

%

70.6

%

Risk-free interest rate

 

4.65

%

2.70

%

4.7

%

2.91

%

Expected life (in years)

 

6.3

 

6.3

 

6.3

 

6.3

 

Weighted average fair value of options granted

 

$

10.88

 

$

13.27

 

$

11.06

 

$

9.18

 

 

The computation of the expected volatility assumption used in the BSM pricing model for new grants is based on implied volatility.  The expected term represents the period that the Company’s stock-based awards are expected to be outstanding and was determined on historical experience of similar awards, giving consideration to contractual terms and vesting provisions of the stock-based awards.  For 2007 option grants, the Company elected to use the “simplified method” as discussed in Staff Accounting Bulletin (“SAB”) No. 107, Share Based Payment (“SAB No. 107”) to develop the estimate for expected term.  On January 1, 2008, the Company adopted SAB No. 110, Certain Assumptions Use in Valuation Methods – Expected Term (“SAB No. 110”).  According to SAB No. 110, under certain circumstances the SEC staff will continue to accept the use of the simplified method as discussed in SAB No. 107, in developing an estimate of expected term of “Plain Vanilla” share options in accordance with SFAS No. 123(R), beyond December 31, 2007.  The risk-free interest rate for the period within the expected term of the option is based on the yield of United States Treasury notes in effect at the time of grant. The Company has not historically paid dividends; thus the expected dividend yield used in the calculation is zero.

 

Restricted Stock Units

 

In the first quarter of 2008, the Compensation Committee of the Board of Directors approved grants of approximately 460,000 restricted stock units to officers and employees of the Company.  During the second quarter of 2008, an additional 25,000 restricted stock units were granted.  The restricted stock units vest over three years at 25% at the end of the first year, 25% at the end of the second year and 50% at the end of the third year and are subject to the employee’s continuing service to the Company.  At June 30, 2008, there were 457,000 restricted stock units that remained outstanding.

 

The cost of restricted stock units is determined using the fair value of the Company’s common stock on the date of the grant and compensation expense is recognized in accordance with the vesting schedule. The weighted average grant date fair values of restricted stock units granted during the three and six months ended June 30, 2008 were as follows:

 

 

 

Three Months Ended

 

Six Months Ended

 

 

 

June 30, 2008

 

June 30. 2008

 

Weighted average fair value of restricted stock units granted

 

$

21.20

 

$

12.65

 

 

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Performance Share Plan

 

In January 2006, the Board of Directors and Compensation Committee adopted the Overstock.com Performance Share Plan (the “Plan”) and approved grants to executive officers and certain employees of the Company. The Plan provides for a three-year period for the measurement of the Company’s attainment of the performance goal described in the form of grant.

 

The performance goal is measured by growth in economic value, as defined in the Plan. The amount of payments due to participants under the Plan will be a function of the then current market price of a share of the Company’s common stock, multiplied by a percentage dependent on the extent to which the performance goal has been attained, which will be between 0% and 200%. If the growth in economic value is 10% compounded annually or less, the percentage will be 0%. If the growth in economic value is 25% compounded annually, the percentage will be 100%. If the growth in economic value is 40% compounded annually or more, the percentage will be 200%. If the percentage growth is between these percentages, the payment percentage will be determined on the basis of straight line interpolation. Amounts payable under the Plan were originally payable in cash. During interim and annual periods prior to the third quarter of 2007, the Company recorded compensation expense based upon the period-end stock price and estimates regarding the ultimate growth in economic value that is expected to occur. These estimates included assumed future growth rates in revenues, gross margins and other factors. If the Company were to use different assumptions, the estimated compensation charges could be significantly different.

 

An amendment to the Plan to allow the Company to make payments in the form of common stock was approved by the shareholders on May 15, 2007. In the third quarter of 2007, the Company determined the fair value of the awards on the amendment date and determined to make the payments in the form of common stock, rather than cash. Therefore, the Company reclassified awards under the Plan from their current status as liability awards to equity awards in accordance with SFAS No. 123(R).

 

As of June 30, 2008, the Company has recognized $1,300,000 in total compensation expense under the Plan. The Company recognized $400,000 and $150,000 in compensation expense under the Plan during the three months ended June 30, 2007 and 2008, respectively.  For the six months ended June 30, 2007 and 2008, the Company recognized $650,000 and $300,000, respectively, in compensation expense related to the Performance Share Plan.

 

12. BUSINESS SEGMENTS

 

Segment information has been prepared in accordance with SFAS No. 131, Disclosures about Segments of an Enterprise and Related Information. Segments were determined based on products and services provided by each segment. There were no inter-segment sales or transfers during the three or six months ended June 30, 2007 and 2008. The Company evaluates the performance of its segments and allocates resources to them based primarily on gross profit. The table below summarizes information about reportable segments for the three and six months ended June 30, 2007 and 2008 (in thousands):

 

 

 

Three months ended June 30,

 

Six months ended June 30,

 

 

 

Direct

 

Fulfillment
Partner

 

Consolidated

 

Direct

 

Fulfillment
partner

 

Consolidated

 

2007

 

 

 

 

 

 

 

 

 

 

 

 

 

Revenue

 

$

43,578

 

$

105,389

 

$

148,967

 

$

89,279

 

$

217,618

 

$

306,897

 

Cost of goods sold

 

36,321

 

86,343

 

122,664

 

75,641

 

179,638

 

255,279

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Gross profit

 

$

7,257

 

$

19,046

 

26,303

 

$

13,638

 

$

37,980

 

51,618

 

Operating expenses

 

 

 

 

 

(39,822

)

 

 

 

 

(82,857

)

Other income (expense), net

 

 

 

 

 

51

 

 

 

 

 

12

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Loss from continuing operations

 

 

 

 

 

$

(13,468

)

 

 

 

 

$

(31,227

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

2008

 

 

 

 

 

 

 

 

 

 

 

 

 

Revenue

 

$

39,939

 

$

148,903

 

$

188,842

 

$

91,422

 

$

298,165

 

$

389,587

 

Cost of goods sold

 

34,752

 

119,985

 

154,737

 

79,066

 

241,630

 

320,696

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Gross profit

 

$

5,187

 

$

28,918

 

34,105

 

$

12,356

 

$

56,535

 

68,891

 

Operating expenses

 

 

 

 

 

(40,422

)

 

 

 

 

(79,520

)

Other income (expense), net

 

 

 

 

 

(146

)

 

 

 

 

257

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Loss from continuing operations

 

 

 

 

 

$

(6,463

)

 

 

 

 

$

(10,372

)

 

The direct segment includes revenues, direct costs, and allocations associated with sales fulfilled from the Company’s

 

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warehouses. Costs for this segment include product costs, inbound and outbound freight, warehousing and fulfillment costs, credit card fees and customer service costs.

 

The fulfillment partner segment includes revenues, direct costs and cost allocations associated with the Company’s third party fulfillment partner sales and are earned from selling the merchandise of third parties over the Company’s Website. The costs for this segment include product costs, partners’ warehousing and fulfillment costs, credit card fees and customer service costs.

 

Assets have not been allocated between the segments for management purposes and, as such, they are not presented here.

 

For the three and six months ended June 30, 2007 and 2008, over 99% of sales were made to customers in the United States of America. No individual geographical area accounted for more than 10% of net sales in any of the periods presented. At December 31, 2007 and June 30, 2008, all of the Company’s fixed assets were located in the United States of America.

 

ITEM 2.   MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

In addition to historical information, this Quarterly Report on Form 10-Q contains forward-looking statements. These statements relate to our, and in some cases our customers’ or other third parties’, future plans, objectives, expectations, intentions and financial performance and the assumptions that underlie these statements. These forward-looking statements include, but are not limited to, statements regarding the following: our beliefs and expectations regarding the seasonality of our direct and fulfillment partner revenue; our beliefs regarding the sufficiency of our capital resources; planned distribution and order fulfillment capabilities; our beliefs, intentions and expectations regarding improvements of our order processing systems and capabilities; our intentions regarding the development of enhanced technologies and features; our intentions regarding the expansion of our customer service capabilities;  our beliefs and intentions regarding enhancements to our sales and marketing activities; our beliefs regarding the potential for growth in our customer base; our beliefs and intentions regarding our expansion into new markets, including international markets; our belief regarding potential development of new Websites; our beliefs, intentions and expectations regarding promotion of new or complimentary product and sales formats; our belief, intentions and expectations regarding the expansion of our product and service offerings; our beliefs and intentions regarding expanding our market presence through relationships with third parties; our beliefs regarding the pursuit of complimentary businesses and technologies; our beliefs regarding the adequacy of our insurance coverage; our beliefs, intentions and expectations regarding litigation matters and legal proceedings, our defenses to such matters and our contesting of such matters; our beliefs and expectations regarding our existing cash and cash equivalents, cash requirements and sufficiency of capital; our beliefs and expectations regarding interest rate risk, our investment activities and the effect of changes in interest rates; our expectation that we will expand our customer service operations and move our corporate headquarters into our new warehouse location; our belief that we have completed the turnaround plan that we began well over a year ago; our intention to expand product selection and our fulfillment partner business; and our belief that our depreciation expense will decrease.

 

These forward-looking statements are subject to risks and uncertainties that could cause actual results and events to differ materially. For a detailed discussion of these risks and uncertainties please see Item 1A — “Risk Factors”. 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.

 

Overview

 

We are an online “closeout” retailer offering discount brand name merchandise, including bed-and-bath goods, home décor, kitchenware, watches, jewelry, electronics and computers, sporting goods, apparel, and designer accessories, among other products. We also sell books, magazines, CDs, DVDs, videocassettes and video games (“BMMG”). We also operate as part of our Website an online auctions business—a marketplace for the buying and selling of goods and services—as well as an online site for dealers to list and customers to find cars for sale, and a real estate site that allows buyers to identify properties listed for sale.

 

We are based in Salt Lake City, Utah, and were founded in 1997. We launched our first Website through which customers could purchase products in March 1999. Our Website offers our customers an opportunity to shop for bargains conveniently, while offering our suppliers an alternative inventory liquidation distribution channel. We continually add new, 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 offer approximately 100,000 products under multiple departments under the shopping tab on our Website, and offer almost 720,000 media products in the Books etc. department on our Website.

 

Closeout merchandise is typically available in inconsistent quantities and often is only available to consumers after it has been purchased and resold by disparate liquidation wholesalers. We believe that the traditional liquidation market is therefore characterized by fragmented supply and fragmented demand. We utilize the Internet to aggregate both supply and demand and create a more efficient market for liquidation merchandise. Our objective is to provide a one-stop destination for discount shopping for

 

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products and services sold through the Internet.

 

Our Business

 

We utilize the Internet to create a more efficient market for liquidation, closeout and other discount merchandise. We provide consumers and businesses with quick and convenient access to high-quality, brand-name merchandise at discount prices. Our shopping business (sales of product offered through the Shopping section of our Website) includes both a “direct” business and a “fulfillment partner” business (see Item 1 of Part I, “Financial Statements (Unaudited)”—Note 12—“Business Segments”). Products from our direct segment and fulfillment partner segments (including products from various industry verticals, such as florist, restaurant, and office supplies) are also available in bulk to both consumers and businesses through the Wholesale product category on our Website.

 

Direct business

 

Our direct business includes sales made to individual consumers and businesses, which are fulfilled from our leased warehouses in Salt Lake City, Utah. During the three and six months ended June 30, 2008, we fulfilled approximately 21% of all orders through our warehouses, which generally ship between 5,000 and 8,000 orders per day and up to approximately 34,000 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 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 fulfillment partner relationships with approximately 870 third parties that post approximately 95,000 non-BMMG products, as well as most of the BMMG products (found in the Books etc. department) on our Website.

 

Our revenue from sales from both the direct and fulfillment partner businesses is recorded net of returns, coupons and other discounts. During the third quarter of 2007, we updated our returns policy. For products other than computers, electronics and mattresses, the returns policy provides for a full refund of the cost of the merchandise and all shipping charges if the product shipped is returned unopened within 30 days of delivery. If the product is returned after 30 days of delivery, is opened or shows signs of wear, the transaction may only be eligible for a partial refund. For items shipped from our Computers and Electronics department, returns must be initiated within 20 days of the purchase date and must be received in the original condition within 30 days of purchase. Computer and Electronics products returned opened or received at our warehouse after 30 days may only qualify for up to a 70 percent refund. Damaged or defective mattresses qualify for a full refund only if the items are refused at the time of delivery.

 

Both direct and fulfillment partner revenues are seasonal, with revenues historically being the highest in the fourth quarter, reflecting higher consumer holiday spending. We anticipate this will continue in the foreseeable future.

 

Unless otherwise indicated or required by the context, the discussion herein of our financial statements, accounting policies and related matters, pertains to the Shopping section of our Website and not necessarily to the Auctions, Cars, Real Estate or Community sections of our Website.

 

Auctions business

 

We operate an online auctions service as part of our Website. Our auctions service allows sellers to list items for sale, buyers to bid on items of interest, and users to browse through listed items online. We record only our listing fees and commissions for items sold as revenue. From time to time, we also sell items returned from our shopping business through our auctions service, and for these sales, we record the revenue on a gross basis. Revenue from our auctions business is included in the fulfillment partner segment, as it is not significant enough to separate out as its own segment.

 

Car listing business

 

We operate an online site for listing cars for sale as a 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. Revenue in the form of monthly listing fees paid by the sellers is recorded on a net basis and is included in the fulfillment partner segment, as it is not significant enough to separate out as its own segment.

 

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Real Estate listing business

 

During May 2008, we added an online site for listing real estate for sale as a part of our Website. The real estate listing service allows customers to search active listings across the country. Listing categories include foreclosures, live and on-line auctions, for sale by owner listings, broker/agent listings and numerous aggregated classified ad listings.  Advertising revenue from the real estate business is included in the fulfillment partner segment, as it is not significant enough to separate out as its own segment.

 

Business Restructuring

 

During the fourth quarter of 2006, we began a facilities consolidation and restructuring program designed to reduce our overall expense structure in an effort to improve future operating performance (see Item 1 of Part I, “Financial Statements (Unaudited)”—Note 3—“Restructuring Expense”).

 

Cost of goods sold

 

Cost of goods sold consists of the cost of the product, as well as inbound and outbound freight, warehousing and fulfillment costs (including payroll and related expenses and stock-based compensation), credit card fees and customer service costs.

 

Operating expenses

 

Sales and marketing expenses consist of advertising, public relations and promotional expenditures, as well as payroll and related expenses, including stock-based compensation, for personnel engaged in marketing and selling activities.

 

Advertising expense is the largest component of our sales and marketing expenses and is primarily attributable to expenditures related to online marketing activities and offline national radio, television and other advertising. Our advertising expenses totaled approximately $7.1 million and $13.1 million for the three months ended June 30, 2007 and 2008, respectively, representing 89% and 92% of sales and marketing expenses for those respective periods.  For the six months ended June 30, 2007 and 2008, our advertising expense totaled approximately $17.7 million and $27.0 million, respectively, representing 92% of sales and marketing expenses for both periods.

 

Technology expenses consist of wages and benefits, including stock-based compensation, for technology personnel, rent, utilities and connectivity charges, as well as support and maintenance and depreciation and amortization related to software and computer equipment.

 

General and administrative expenses consist of wages and benefits, including stock-based compensation, for executive, legal, accounting, merchandising and administrative personnel, rent and utilities, travel and entertainment, depreciation and amortization of intangible assets and other general corporate expenses.

 

We have recorded no provision or benefit for federal and state income taxes as we have incurred net operating losses since inception. We have provided a full valuation allowance on the net deferred tax assets, consisting primarily of net operating loss carryforwards, because of uncertainty regarding their realizability.

 

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 in this report. This executive commentary includes forward-looking statements, and investors are cautioned to read the “Special Note Regarding Forward-Looking Statements” included elsewhere in this report.

 

Commentary—Revenue.   Total revenue for Q2 2008 increased to $188.8 million, a 27% improvement over Q2 2007, and the same rate of growth we experienced in Q1 2008. Strong fulfillment partner revenue, which grew 41% and accounted for nearly 80% of total revenues, was the primary driver of growth this quarter. Our initiative to increase selection on our website continued throughout the second quarter, and we believe is a major reason for accelerating fulfillment partner revenue growth. We ended the quarter with approximately 100,000 SKUs on the site compared to 43,000 at the end of Q2 last year. We are adding products to existing and new categories, and these are coming from both existing and new fulfillment partners (we ended this quarter with 870 fulfillment partners, up from 550 a year ago).  Direct revenue on the other hand, decreased 8% from last year due primarily to sales in some categories shifting from direct to fulfillment partners.

 

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Increases in traffic to our website, new and unique customers, customer orders, and average order value each contributed positively to revenue growth this quarter.  See Commentary—Marketing below for more information on our sales and marketing efforts.

 

Commentary—Gross Profit and Gross Margin.  Gross profit increased 30% to $34.1 million as a result of a shift in sales mix to higher margin categories. Fulfillment partner gross profit expanded 52% to $28.9 million, while direct gross profit contracted by 29% to $5.2 million. Like revenues, fulfillment partner margins benefited  from a mix shift of higher-margin sales from direct to fulfillment partners.

 

Gross margin for the quarter improved 40 basis points (“bps”) to 18.1%, the highest in our history. Fulfillment partner gross margin expanded 130bps to 19.4%, while direct margin contracted 370 bps to 13.0%. The second quarter is traditionally our highest margin quarter of the year. This is due primarily to the mix of products typically sold during the period.  Gross margins quarter also benefited in part by the continued shift from lower margin BMMG products, which decreased from 6.8% of total gross revenue last year to 4.3% this year. Fulfillment costs were down 100 bps, primarily the result of improved efficiencies in our warehousing and customer service operations.  Gross margin for the past six quarterly periods and fiscal year ending 2007 was:

 

 

 

Q1 2007

 

Q2 2007

 

Q3 2007

 

Q4 2007

 

FY 2007

 

Q1 2008

 

Q2 2008

 

YTD Q2
2008

 

Direct

 

14.0

%

16.7

%

15.9

%

16.9

%

16.0

%

13