Can This Stock Go Even Higher?

Brian is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Overstock.com (NASDAQ: OSTK) has emerged as a market favorite in the e-commerce space. The stock is trading higher by 20% on Thursday, with one-year gains of 425%, and I am going to show you how it could still go higher!

What’s taking this stock higher?

Overstock.com’s 16-month rally has been the effect of a two-part cause. Initially, in 2012, revenue growth was slow, but margin expansion was rapid, which pushed its shares from $5 to $15 rather quickly.

Then, in the last two quarters, continued margin improvement combined with accelerated revenue growth has pushed shares to a new level, near $35.

While many may think that no further upside exists, as I look at the company, I still see a cheap stock with significant upside potential.

The big 3 & the best 1

The big three in e-commerce are Amazon (NASDAQ: AMZN), eBay (NASDAQ: EBAY), and lastly Overstock.com. Strangely, on a day where Overstock.com shows significant fundamental strength, eBay shows weakness, falling lower by nearly 7%.

eBay posted top-line growth of 14%, as its user base continues to outperform sales growth. However, eBay is not why I think Overstock.com still has room to run higher, but rather three specific metrics.

 

Amazon

eBay

Overstock.com

Price/Sales

2.20

5.12

0.57

Operating Margin

1%

21%

2%

Revenue Growth (MRQ)

21.9%

14%

22%

You should first note that Amazon is not a company whose primary concern is margins. The company has said that its focus is on reinvesting its revenue into the business so that it can grow. One way is by cutting prices to near the cost of production.

There is a belief on Wall Street that Amazon could flip a switch, change its approach, and return margins of 3-5% at any point they desired. This is yet to be seen, but with all of the company’s gross profit spent on SG&A and R&D, this thinking does appear logical.

eBay earns a large chunk of its profit from PayPal, but its core business also produces greater margins than what we see with Amazon. In fact, the company returns more than 5% of its revenue as operating profit with its core business. Therefore, 5% operating margins seem to be the standard for effective business management in the e-commerce space.

Overstock.com has operating margins of just 2%, which is one of the reasons that it has improved so rapidly. During its last quarter, Overstock’s earnings grew 183% and during this current quarter, income grew 687% year-over-year. This shows the rate at which Overstock.com is improving its bottom line, and with margins of just 2%, the company still has a lot of room to improve its bottom line.

While both Amazon and Overstock.com have similar revenue growth, eBay is lagging, but because of eBay’s margins it trades with a higher price/sales ratio. Since Overstock.com does not have an equivalent to PayPal, Amazon’s 2.2 times sales valuation should be used as the potential for Overstock.com.

Overstock at 0.57 would theoretically allow for upside of 400% to equal the valuation of Amazon. While this may sound unlikely, you must remember that Overstock.com is only this cheap because people wrote the company off as a serious competitor to eBay and Amazon in the past. Now, with its re-emergence, significant gains are likely.

Final thoughts

Overstock.com rapidly fell from 2005 to 2011 as eBay and Amazon emerged as clear winners. However, Overstock.com’s new approach on profitability, and its sudden gains in revenue have changed the landscape. The stock is now surging higher to try and cover the ground that separates it from Amazon and eBay in terms of valuation. If Overstock.com can maintain this growth, and continue to improve, then I see no reason why its large run higher cannot continue. Because after all, it is still cheap compared to its space. 

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Brian Nichols has no position in any stocks mentioned. The Motley Fool recommends Amazon.com and eBay. The Motley Fool owns shares of Amazon.com and eBay. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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