OSTK-2014.03.31-10Q
Table of Contents

 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
FORM 10-Q
 
(Mark One)
ý
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 For the quarterly period ended March 31, 2014
 
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 incorporation or organization)
 
(I.R.S. Employer Identification Number)
 
 
 
6350 South 3000 East, Salt Lake City, Utah 84121
 
(801) 947-3100
(Address, including zip code, of Registrant’s principal executive offices)
 
(Registrant’s telephone number, including area code)
 
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 ý   No o
 
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes ý   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 the definitions of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
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 ý
 
There were 23,980,588 shares of the Registrant’s common stock, par value $0.0001, outstanding on April 21, 2014.




Table of Contents

TABLE OF CONTENTS
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 

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PART I. FINANCIAL INFORMATION
 
ITEM 1. FINANCIAL STATEMENTS (UNAUDITED)

Overstock.com, Inc.
Consolidated Balance Sheets (Unaudited)
(in thousands)
 
 
March 31,
2014
 
December 31,
2013
Assets
 

 
 

Current assets:
 

 
 

Cash and cash equivalents
$
110,647

 
$
148,665

Restricted cash
1,580

 
1,580

Accounts receivable, net
15,836

 
16,047

Inventories, net
22,773

 
27,043

Prepaid inventories, net
1,665

 
1,804

Deferred tax assets, net
13,854

 
13,854

Prepaids and other current assets
10,035

 
10,298

Total current assets
176,390

 
219,291

Fixed assets, net
33,417

 
27,194

Precious metals
9,678

 
9,678

Deferred tax assets, net
56,480

 
58,797

Goodwill
2,784

 
2,784

Other long-term assets, net
1,829

 
2,023

Total assets
$
280,578

 
$
319,767

Liabilities and Stockholders’ Equity
 

 
 

Current liabilities:
 

 
 

Accounts payable
$
62,219

 
$
90,582

Accrued liabilities
51,854

 
65,679

Deferred revenue
36,843

 
37,321

Total current liabilities
150,916

 
193,582

Other long-term liabilities
3,997

 
3,294

Total liabilities
154,913

 
196,876

Commitments and contingencies (Note 5)
0

 
0

Stockholders’ equity:
 

 
 

Preferred stock, $0.0001 par value:
 

 
 

Authorized shares - 5,000
 

 
 

Issued and outstanding shares - none

 

Common stock, $0.0001 par value
 

 
 

Authorized shares - 100,000
 

 
 

Issued shares - 27,173 and 26,909
 

 
 

Outstanding shares - 23,971 and 23,785
2

 
2

Additional paid-in capital
362,800

 
361,706

Accumulated deficit
(154,617
)
 
(158,587
)
Treasury stock:
 

 
 

Shares at cost - 3,202 and 3,124
(82,520
)
 
(80,230
)
Total stockholders’ equity
125,665

 
122,891

Total liabilities and stockholders’ equity
$
280,578

 
$
319,767

 
See accompanying notes to unaudited consolidated financial statements.

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Overstock.com, Inc.
Consolidated Statements of Income and Comprehensive Income (Unaudited)
(in thousands, except per share data)
 
 
Three months ended  
 March 31,
 
2014
 
2013
Revenue, net
 

 
 

Direct
$
38,047

 
$
41,942

Fulfillment partner
303,160

 
270,052

Total net revenue
341,207

 
311,994

Cost of goods sold
 

 
 

Direct(1)
33,097

 
37,149

Fulfillment partner
244,114

 
215,909

Total cost of goods sold
277,211

 
253,058

Gross profit
63,996

 
58,936

Operating expenses:
 

 
 

Sales and marketing(1)
23,392

 
18,705

Technology(1)
19,601

 
18,160

General and administrative(1)
15,296

 
15,088

Restructuring
(360
)
 
(432
)
Total operating expenses
57,929

 
51,521

Operating income
6,067

 
7,415

Interest income
41

 
34

Interest expense
(7
)
 
(51
)
Other income, net
459

 
345

Income before income taxes
6,560

 
7,743

Provision for income taxes
2,590

 
46

Net income
$
3,970

 
$
7,697

Net income per common share—basic:
 

 
 

Net income attributable to common shares—basic
$
0.17

 
$
0.33

Weighted average common shares outstanding—basic
23,926

 
23,594

Net income per common share—diluted:
 

 
 

Net income attributable to common shares—diluted
$
0.16

 
$
0.32

Weighted average common shares outstanding—diluted
24,339

 
24,016

 
 
 
 
Comprehensive income
$
3,970

 
$
7,697

________________________________________
(1) Includes stock-based compensation as follows (Note 7):
 

 
 

 Cost of goods sold — direct
$
40

 
$
48

 Sales and marketing
81

 
25

 Technology
170

 
124

 General and administrative
632

 
555

 Total
$
923

 
$
752

 
See accompanying notes to unaudited consolidated financial statements.

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Overstock.com, Inc.
Consolidated Statements of Changes in Stockholders’ Equity (Unaudited)
(in thousands)
 
 
 
 
 
 
Additional
 
 
 
 
 
 
 
Common stock
 
Paid-in
 
Accumulated
 
Treasury stock
 
 
 
Shares
 
Amount
 
Capital
 
Deficit
 
Shares
 
Amount
 
Total
Balances at December 31, 2013
26,909

 
$
2

 
$
361,706

 
$
(158,587
)
 
3,124

 
$
(80,230
)
 
$
122,891

Net income

 

 

 
3,970

 

 

 
3,970

Stock-based compensation to employees and directors

 

 
923

 

 

 

 
923

Common stock issued upon vesting of restricted stock
254

 

 

 

 

 

 

Exercise of stock options
10

 

 
171

 

 

 

 
171

Purchase of treasury stock

 

 

 

 
78

 
(2,290
)
 
(2,290
)
Balances at March 31, 2014
27,173

 
$
2

 
$
362,800

 
$
(154,617
)
 
3,202

 
$
(82,520
)
 
$
125,665

 
See accompanying notes to unaudited consolidated financial statements.

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Overstock.com, Inc.
Consolidated Statements of Cash Flows (Unaudited)
(in thousands)
 
Three months ended  
 March 31,
 
Twelve months ended 
 March 31,
 
2014
 
2013
 
2014
 
2013
Cash flows from operating activities:
 

 
 

 
 

 
 

Net income
$
3,970

 
$
7,697

 
$
84,782

 
$
19,647

Adjustments to reconcile net income to net cash provided by (used in) operating activities:
 

 
 

 
 

 
 

Depreciation and amortization
3,795

 
3,863

 
14,454

 
15,838

Realized gain from sale of marketable securities
(10
)
 
(12
)
 
(31
)
 
(14
)
Loss (gain) on disposition of fixed assets
5

 

 
5

 
(13
)
Stock-based compensation to employees and directors
923

 
752

 
3,422

 
3,466

Deferred income taxes
2,317

 

 
(70,334
)
 

Amortization of debt discount and deferred loan costs

 
5

 
13

 
43

Loss on investment in precious metals

 

 
1,457

 

Restructuring charges (reversals)
(360
)
 
(432
)
 
(399
)
 
(454
)
Changes in operating assets and liabilities:
 

 
 

 
 

 
 

Restricted cash

 
125

 
75

 
273

Accounts receivable, net
211

 
3,422

 
15

 
(3,910
)
Inventories, net
4,270

 
4,929

 
(1,238
)
 
(4,890
)
Prepaid inventories, net
139

 
(76
)
 
323

 
(78
)
Prepaids and other current assets
174

 
1,462

 
(1,824
)
 
(400
)
Other long-term assets, net
221

 
53

 
170

 
(908
)
Accounts payable
(31,909
)
 
(15,729
)
 
12,000

 
3,956

Accrued liabilities
(13,718
)
 
(748
)
 
4,989

 
11,004

Deferred revenue
(478
)
 
(6,880
)
 
5,312

 
4,717

Other long-term liabilities
771

 
(84
)
 
2,428

 
449

Net cash provided by (used in) operating activities
(29,679
)
 
(1,653
)
 
55,619

 
48,726

Cash flows from investing activities:
 

 
 

 
 

 
 

Purchases of marketable securities
(12
)
 
(75
)
 
(69
)
 
(119
)
Purchases of intangible assets
(22
)
 

 
(35
)
 
(6
)
Sales of marketable securities
77

 
152

 
217

 
189

Investment in precious metals

 

 
(8,080
)
 
(1,397
)
Expenditures for fixed assets, including internal-use software and website development
(6,195
)
 
(6,062
)
 
(18,200
)
 
(16,424
)
Proceeds from sale of fixed assets

 

 

 
56

Net cash used in investing activities
(6,152
)
 
(5,985
)
 
(26,167
)
 
(17,701
)
Cash flows from financing activities:
 

 
 

 
 

 
 

Payments on capital lease obligations

 
(2,563
)
 

 
(2,598
)
Payments on line of credit

 

 

 
(17,000
)
Paydown on direct financing arrangement
(68
)
 
(62
)
 
(264
)
 
(241
)
Change in restricted cash

 

 
125

 

Proceeds from exercise of stock options
171

 

 
1,731

 

Purchase of treasury stock
(2,290
)
 
(1,389
)
 
(2,292
)
 
(1,396
)
Net cash used in financing activities
(2,187
)
 
(4,014
)
 
(700
)
 
(21,235
)
Net increase (decrease) in cash and cash equivalents
(38,018
)
 
(11,652
)
 
28,752

 
9,790

Cash and cash equivalents, beginning of period
148,665

 
93,547

 
81,895

 
72,105

Cash and cash equivalents, end of period
$
110,647

 
$
81,895

 
$
110,647

 
$
81,895


Continued on the following page

Overstock.com, Inc.
Consolidated Statements of Cash Flows (Unaudited)
(Continued)
(in thousands)
 
Three months ended  
 March 31,
 
Twelve months ended 
 March 31,
 
2014
 
2013
 
2014
 
2013
Supplemental disclosures of cash flow information:
 

 
 

 
 

 
 

Cash paid during the period:
 

 
 

 
 

 
 

Interest paid
$
14

 
$
20

 
$
65

 
$
453

Taxes paid

 
283

 
263

 
580

Non-cash investing and financing activities:
 

 
 

 
 

 
 

Fixed assets, including internal-use software and website development, costs financed through accounts payable and accrued liabilities
$
4,018

 
$
116

 
$
4,121

 
$
497

Equipment acquired under capital lease obligations

 
2,563

 

 
2,563


See accompanying notes to unaudited consolidated financial statements.


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Overstock.com, Inc.
Notes to Unaudited Consolidated Financial Statements
 
1. BASIS OF PRESENTATION
 
As used herein, “Overstock,” “Overstock.com,” “O.co,” “we,” “our” and similar terms include Overstock.com, Inc. and its subsidiaries, unless the context indicates otherwise. We have prepared the accompanying unaudited consolidated financial statements pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”) 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 our audited annual consolidated financial statements and related notes included in our Annual Report on Form 10-K for the year ended December 31, 2013. The accompanying unaudited consolidated financial statements reflect all adjustments, consisting only of normal recurring adjustments, which are, in our opinion, necessary for a fair presentation of results for the interim periods presented. Preparing financial statements requires us 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 our best knowledge of current events and actions that we may undertake in the future, actual results may be different from the estimates. The results of operations for the three months ended March 31, 2014 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 our accounts and the accounts of our wholly-owned subsidiaries. All 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, investment valuation, receivables valuation, revenue recognition, sales returns, incentive discount offers, inventory valuation, depreciable lives of fixed assets and internally-developed software, goodwill valuation, intangible valuation, income taxes, stock-based compensation, performance-based compensation, restructuring liabilities and contingencies. Actual results could differ materially from those estimates.
 
Cash equivalents
 
We classify all highly liquid instruments, including money market funds with a remaining maturity of three months or less at the time of purchase, as cash equivalents. Cash equivalents were $68.1 million and $58.1 million at March 31, 2014 and December 31, 2013, respectively.
 
Restricted cash
 
We consider cash that is legally restricted and cash that is held as a compensating balance for letter of credit arrangements as restricted cash. Restricted cash was $1.6 million at March 31, 2014 and December 31, 2013.
 
Fair value of financial instruments
 
Our financial instruments, including cash, cash equivalents, restricted cash, accounts receivable, accounts payable and accrued liabilities are carried at cost, which approximates their fair value because of the short-term maturity of these instruments.
 
We account for our assets and liabilities using 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 our market assumptions. These two types of inputs have created the following fair-value hierarchy:
Level 1—Quoted prices for identical instruments in active markets; 

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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 us 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 instruments was determined using the following levels of inputs as of March 31, 2014 (in thousands): 
 
Fair Value Measurements at March 31, 2014:
 
Total
 
Level 1
 
Level 2
 
Level 3
Assets:
 

 
 

 
 

 
 

Cash equivalents - Money market mutual funds
$
68,083

 
$
68,083

 
$

 
$

Trading securities held in a “rabbi trust” (1)
75

 
75

 

 

Total assets
$
68,158

 
$
68,158

 
$

 
$

Liabilities:
 

 
 

 
 

 
 

Deferred compensation accrual “rabbi trust” (2)
$
79

 
$
79

 
$

 
$

Total liabilities
$
79

 
$
79

 
$

 
$

 
The fair value of these financial instruments was determined using the following levels of inputs as of December 31, 2013 (in thousands): 
 
Fair Value Measurements at December 31, 2013:
 
Total
 
Level 1
 
Level 2
 
Level 3
Assets:
 

 
 

 
 

 
 

Cash equivalents - Money market mutual funds
$
58,081

 
$
58,081

 
$

 
$

Trading securities held in a “rabbi trust” (1)
138

 
138

 

 

Total assets
$
58,219

 
$
58,219

 
$

 
$

Liabilities:
 

 
 

 
 

 
 

Deferred compensation accrual “rabbi trust” (2)
$
212

 
$
212

 
$

 
$

Total liabilities
$
212

 
$
212

 
$

 
$

 ___________________________________________
(1)
 — Trading securities held in a rabbi trust are included in Other current and long-term assets in the consolidated balance sheets.
 
(2)
— Non qualified deferred compensation in a rabbi trust is included in Accrued liabilities and Other long-term liabilities in the consolidated balance sheets.
  
Restricted investments
 
We have a Non Qualified Deferred Compensation Plan (the “NQDC Plan”) for senior management. Deferred compensation amounts are invested in mutual funds held in a “rabbi trust” and are restricted for payment to the participants of the NQDC Plan. We account for our investments held in the trust in accordance with Accounting Standards Codification (“ASC”) No. 320 “Investments — Debt and Equity Securities”. The investments held in the trust are classified as trading securities. The fair value of the investments held in the trust totaled $75,000 at March 31, 2014 and are included in Other current and long-term assets in the consolidated balance sheets. Our gains and losses on these investments were immaterial for the three months ended March 31, 2014 and 2013.
 
Accounts receivable
 
Accounts receivable consist primarily of trade amounts due from customers and from uncleared credit card transactions at period end. Accounts receivable are recorded at invoiced amounts and do not bear interest.

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Allowance for doubtful accounts
 
From time to time, we grant credit to some of our business customers on normal credit terms (typically 30 days). We perform credit evaluations of our business customers’ financial condition and payment history and maintain an allowance for doubtful accounts receivable based upon our historical collection experience and expected collectability of accounts receivable. The allowance for doubtful accounts receivable was $211,000 and $152,000 at March 31, 2014 and December 31, 2013, respectively.

Concentration of credit risk
 
Cash equivalents include short-term, highly liquid instruments with maturities at date of purchase of three months or less. At March 31, 2014 and December 31, 2013, two banks held the majority of our cash and cash equivalents. We do not believe that, as a result of this concentration, we are subject to any unusual financial risk beyond the normal risk associated with commercial banking relationships.
 
Financial instruments that potentially subject us to significant concentrations of credit risk consist primarily of cash equivalents and receivables. We invest our cash primarily in money market securities which are uninsured.
 
Our accounts receivable are derived primarily from revenue earned from customers located in the United States. We maintain an allowance for doubtful accounts based upon the expected collectability of accounts receivable.
 
Valuation of inventories
 
Inventories, consisting of merchandise purchased for resale, are accounted for using a standard costing system which approximates the first-in-first-out (“FIFO”) method of accounting, and are valued at the lower of cost or market. We write down our inventory for estimated obsolescence and to lower of cost or market value based upon assumptions about future demand and market conditions. If actual market conditions are less favorable than those projected by management, additional inventory write-downs may be required. Once established, the original cost of the inventory less the related inventory allowance represents the new cost basis of such products. Reversal of the allowance is recognized only when the related inventory has been sold or scrapped.
 
Prepaid inventories, net
 
Prepaid inventories represent inventories paid for in advance of receipt. Prepaid inventories were $1.7 million and $1.8 million at March 31, 2014 and December 31, 2013, respectively.

Prepaids and other current assets
 
Prepaids and other current assets represent expenses paid prior to receipt of the related goods or services, including advertising, license fees, maintenance, packaging, insurance, and other miscellaneous costs. Total prepaids and other assets were $10.0 million at March 31, 2014 and $10.3 million at December 31, 2013.
 
Fixed assets
 
Fixed assets, which include assets such as technology infrastructure, internal-use software, website development, furniture and fixtures and leasehold improvements, are recorded at cost and depreciated using the straight-line method over the estimated useful lives of the related assets or the term of the related capital lease, whichever is shorter, as follows: 
 
Life
(years)
Computer software
2-4
Computer hardware
3-4
Furniture and equipment
3-5
 
Leasehold improvements are amortized over the shorter of the term of the related leases or estimated useful lives.


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Depreciation and amortization expense is classified within the corresponding operating expense categories on the consolidated statements of income and comprehensive income as follows (in thousands): 
 
Three months ended  
 March 31,
 
2014
 
2013
Cost of goods sold - direct
$
87

 
$
104

Technology
3,437

 
3,416

General and administrative
271

 
343

Total depreciation and amortization, including internal-use software and website development
$
3,795

 
$
3,863

 
Internal-use software and website development
 
Included in fixed assets is the capitalized cost of internal-use software and website development, including software used to upgrade and enhance our Website and processes supporting our business. We capitalize costs incurred during the application development stage of internal-use software and amortize these costs over the estimated useful life of two to three years. Costs incurred related to design or maintenance of internal-use software are expensed as incurred.
 
During the three months ended March 31, 2014 and 2013, we capitalized $4.0 million and $3.0 million, respectively, of costs associated with internal-use software and website development, both developed internally and acquired externally. Amortization of costs associated with internal-use software and website development was $2.3 million and $1.7 million for those respective periods.
 
Leases
 
We account for lease agreements as either operating or capital leases depending on certain defined criteria. In certain of our lease agreements, we receive rent holidays and other incentives. We recognize lease costs on a straight-line basis without regard to deferred payment terms, such as rent holidays, that defer the commencement date of required payments. Additionally, tenant improvement allowances are amortized as a reduction in rent expense over the term of the lease. Leasehold improvements are capitalized at cost and amortized over the lesser of their expected useful life or the life of the lease, without assuming renewal features, if any, are exercised.
 
Treasury stock
 
We account for treasury stock under the cost method and include treasury stock as a component of stockholders’ equity.
 
Other long-term assets
 
Other long-term assets consist primarily of long-term prepaid expenses.
 
Impairment of long-lived assets
 
We review property and equipment and other long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset group may not be recoverable. Recoverability is measured by comparison of the assets’ carrying amount to future undiscounted net cash flows the asset group is expected to generate. Cash flow forecasts are based on trends of historical performance and management’s estimate of future performance, giving consideration to existing and anticipated competitive and economic conditions. If such asset group is considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the assets exceeds their fair values. There were no impairments to long-lived assets recorded during the three months ended March 31, 2014 and the year ended December 31, 2013.
 
Precious Metals
 
Our investments in precious metals were $9.7 million at March 31, 2014 and December 31, 2013, and were comprised of $4.0 million in gold and $5.7 million in silver. We store our precious metals at an off-site facility. Because these assets consist of actual precious metals, rather than financial instruments, we account for them as a cost method investment initially

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recorded at cost (including transaction fees) and then adjusted to the lower of cost of market based on an average unit cost. On an interim basis, we recognize decreases in the value of these assets caused by market declines. Subsequent increases in the value of these assets through market price recoveries during the same fiscal year are recognized in the later interim period, but may not exceed the total previously recognized decreases in value during the same year. Gains or losses resulting from changes in the value of our precious metal assets are recorded in Other income, net in our Consolidated Statements of Income and Comprehensive Income. There were no gains or losses on investments in precious metals for the three months ended March 31, 2014 and 2013.

Goodwill
 
Goodwill represents the excess of the purchase price paid over the fair value of the tangible net assets acquired in business combinations.
 
Goodwill is not amortized but is tested for impairment at least annually. When evaluating whether goodwill is impaired, we make a qualitative assessment to determine if it is more likely than not that its fair value is less than its carrying amount. If the qualitative assessment determines that it is more likely than not that its fair value is less than its carrying amount, we compare the fair value of the reporting unit to which the goodwill is assigned to its carrying amount. If the carrying amount exceeds its fair value, then the amount of the impairment loss must be measured. The impairment loss, if any, is calculated by comparing the implied fair value of the goodwill to its carrying amount. In calculating the implied fair value of goodwill, the fair value of the reporting unit is allocated to the other assets and liabilities within the reporting unit based on estimated fair value. The excess of the fair value of a reporting unit over the amount allocated to its other assets and liabilities is the implied fair value of goodwill. An impairment loss is recognized when the carrying amount of goodwill exceeds its implied fair value.
 
In accordance with this guidance, we test for impairment of goodwill in the fourth quarter or when we deem that a triggering event has occurred. Goodwill totaled $2.8 million at March 31, 2014 and December 31, 2013, respectively. There were no impairments to goodwill recorded during the three months ended March 31, 2014 or the year ended December 31, 2013.
 
Revenue recognition
 
We derive our revenue primarily from direct revenue and fulfillment partner revenue from merchandise sales. We also earn revenue from advertising on our shopping and other pages. We have organized our operations into two principal segments based on the primary source of revenue: direct revenue and fulfillment partner revenue (see Note 8—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 our customers. As we ship high volumes of packages through multiple carriers, it is not practical for us to track the actual delivery date of each shipment. Therefore, we use estimates to determine which shipments are delivered and, therefore, recognized as revenue at the end of the period. Our delivery date estimates are based on average shipping transit times, which are calculated using the following factors: (i) the type of shipping carrier (as carriers have different in-transit times); (ii) the fulfillment source (either our warehouses or those of our fulfillment partners); (iii) the delivery destination; and (iv) actual transit time experience, which shows that delivery date is typically one to eight business days from the date of shipment. We review and update our estimates on a quarterly basis based on our actual transit time experience. However, actual shipping times may differ from our estimates.
 
We evaluate the criteria outlined in ASC Topic 605-45, Principal Agent Considerations, 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 we are the primary obligor in a transaction, are subject to inventory risk, have latitude in establishing prices and selecting suppliers, or have several but not all of these indicators, revenue is recorded gross. If we are not the primary obligor in the transaction and amounts earned are determined using a fixed percentage, revenue is recorded on a net basis. Currently, the majority of both direct revenue and fulfillment partner revenue is recorded on a gross basis, as we are the primary obligor. We present revenue net of sales taxes.
 
We periodically provide incentive offers to our customers to encourage purchases. Such offers include current discount offers, such as percentage discounts off current purchases and other similar offers, which, when used by customers, are treated as a reduction of revenue.
 

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Based upon our historical experience, revenue typically increases during the fourth quarter because of the holiday retail season.
 
Direct revenue
 
Direct revenue is derived from merchandise sales to individual consumers and businesses that are fulfilled from our warehouses. Direct revenue comes from merchandise sales that occur primarily through our Website, but may also occur through offline and other channels.
 
Fulfillment partner revenue
 
Fulfillment partner revenue is derived from merchandise sales which fulfillment partners ship directly to consumers and businesses from warehouses maintained by our fulfillment partners. Fulfillment partner revenue comes from merchandise sales that occur primarily through our Website, but may also occur through offline and other channels.
 
Club O loyalty program
 
We have a customer loyalty program called Club O for which we sell annual memberships. We record membership fees as deferred revenue and we recognize revenue ratably over the membership period. The Club O loyalty program allows members to earn reward dollars for qualifying purchases made on our Website. We also have a co-branded credit card program (see “Co-branded credit card revenue” below for more information). Co-branded cardholders are also Club O members and earn additional reward dollars for purchases made on our Website, and from other merchants. Reward dollars earned may be redeemed on future purchases made through our Website. Club O reward dollars expire 90 days after the customer’s Club O membership expires. We account for these transactions as multiple element arrangements and allocate revenue to the elements using their relative fair values. We include the value of reward dollars earned in deferred revenue and we record it as a reduction of revenue at the time the reward dollars are earned.
 
We recognize revenue for Club O reward dollars when customers redeem their reward dollars as part of a purchase at our Website. We recognize other income when Club O reward dollars expire or the likelihood of reward dollars being redeemed by a customer is remote (“reward dollar breakage”). Reward dollar breakage is currently recognized when the reward dollars expire.
 
In instances where customers receive free Club O reward dollars not associated with any purchases, we account for these transactions as sales incentives such as coupons and record a reduction of revenue at the time the reward dollars are redeemed.
 
Co-branded credit card program
 
We have a co-branded credit card agreement with a commercial bank for the issuance of credit cards bearing the Overstock.com brand, under which the bank pays us fees for new accounts and for customer usage of the cards. The agreement also provides for a customer loyalty program offering reward points that customers will accrue from card usage and can use to make purchases on our Website (see “Club O loyalty program” above for more information). New account fees are recognized as revenue on a straight-line basis over the remaining life of the credit card relationship which runs through April 2015. Credit card usage fees are recognized as revenues as actual credit card usage occurs. Revenues from new account and credit card usage fees were less than 1% of total net revenues for all periods presented.

Deferred revenue
 
Customer orders are recorded as deferred revenue prior to delivery of products or services ordered. We record amounts received for Club O membership fees as deferred revenue and we recognize it ratably over the membership period. We record Club O reward dollars earned from purchases as deferred revenue at the time they are earned and we recognize it as revenue upon redemption. If reward dollars are not redeemed, we recognize other income upon expiration. In addition, we sell gift cards and record related deferred revenue at the time of the sale. We sell gift cards without expiration dates and we recognize revenue from a gift card upon redemption of the gift card. If a gift card is not redeemed, we recognize other income when the likelihood of its redemption becomes remote based on our historical redemption experience. We consider the likelihood of redemption to be remote after 36 months.


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We periodically enter into agreements with other parties to jointly market ancillary products or services on our website. As a result of those agreements, we will occasionally receive payments in advance of performing our obligations under those agreements. Such payments received before we perform our obligations are recognized over our service period.

Sales returns allowance
 
We inspect returned items when they arrive at our processing facility. We refund the full cost of the merchandise returned and all original shipping charges if the returned item is defective or we or our fulfillment partners have made an error, such as shipping the wrong product.
 
If the return is not a result of a product defect or a fulfillment error and the customer initiates a return of an unopened item within 30 days of delivery, for most products we refund the full cost of the merchandise minus the original shipping charge and actual return shipping fees. However, we reduce refunds for returns initiated more than 30 days after delivery or that are received at our returns processing facility more than 45 days after initial delivery.
 
If our customer returns an item that has been opened or shows signs of wear, we issue a partial refund minus the original shipping charge and actual return shipping fees.
 
Revenue is recorded net of estimated returns. We record an allowance for returns based on current period revenues and historical returns experience. We analyze actual historical returns, current economic trends and changes in order volume and acceptance of our products when evaluating the adequacy of the sales returns allowance in any accounting period.
 
The allowance for returns was $8.9 million and $13.2 million at March 31, 2014 and December 31, 2013 respectively. The decrease in allowance for returns at March 31, 2014 compared to December 31, 2013 is primarily due to decreased revenues mostly due to seasonality.
 
Credit card chargeback allowance
 
Revenue is recorded net of credit card chargebacks. We maintain an allowance for credit card chargebacks based on current period revenues and historical chargeback experience. The allowance for chargebacks was $99,000 and $94,000 at March 31, 2014 and December 31, 2013, respectively.
 
Cost of goods sold
 
Cost of goods sold includes product costs, warehousing costs, outbound shipping costs, handling and fulfillment costs, customer service costs and credit card fees, and is recorded in the same period in which related revenues have been recorded. Cost of goods sold, including product cost and other costs and fulfillment and related costs are as follows (in thousands):
 
 
Three months ended  
 March 31,
 
2014
 
2013
Total revenue, net
$
341,207

 
100
%
 
$
311,994

 
100
%
Cost of goods sold
 

 
 

 
 

 
 

Product costs and other cost of goods sold
261,798

 
77
%
 
239,197

 
77
%
Fulfillment and related costs
15,413

 
5
%
 
13,861

 
4
%
Total cost of goods sold
277,211

 
81
%
 
253,058

 
81
%
Gross profit
$
63,996

 
19
%
 
$
58,936

 
19
%
 
Advertising expense
 
We expense the costs of producing advertisements the first time the advertising takes place and expense 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: 1) a commission for traffic driven to the Website that generates a sale or 2) a referral fee based on the number of clicks on keywords or links to our Website generated during a given period. Advertising expense is included in sales and marketing expenses and totaled $20.4 million and $16.5 million during the three months ended March 31, 2014 and 2013, respectively. Prepaid advertising (included in Prepaids

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and other current assets in the accompanying consolidated balance sheets) was $1.0 million and $1.4 million at March 31, 2014 and December 31, 2013, respectively.
 
Stock-based compensation
 
We measure compensation expense for all outstanding unvested share-based awards at fair value on the date of grant and recognize compensation expense over the service period for awards expected to vest at the greater of a straight line basis or on an accelerated schedule when vesting of restricted stock awards exceeds a straight line basis. The estimation of stock awards that will ultimately vest requires judgment, and to the extent actual results differ from estimates, such amounts will be recorded as an adjustment in the period estimates are revised. We consider many factors when estimating expected forfeitures, including types of awards, and historical experience. Actual results may differ substantially from these estimates (see Note 7—Stock-Based Awards).
 
Loss contingencies
 
In the normal course of business, we are involved in legal proceedings and other potential loss contingencies. We accrue a liability for such matters when it is probable that a loss has been incurred and the amount can be reasonably estimated. When only a range of probable loss can be estimated, the most probable amount in the range is accrued. If no amount within this range is a better estimate than any other amount within the range, the minimum amount in the range is accrued. We expense legal fees as incurred (see Note 5—Commitments and Contingencies).
 
Restructuring
 
Restructuring expenses are primarily comprised of lease termination costs. ASC Topic 420, Accounting for Costs Associated with Exit or Disposal Activities, requires that when an entity ceases using a property that is leased under an operating lease before the end of the contractual term, 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).
 
Income taxes
 
Our tax provision from income taxes for interim periods is determined using an estimate of our annual effective tax rate, adjusted for discrete items, if any, that are taken into account in the relevant period. Each quarter we update our estimate of the annual effective tax rate, and if our estimated tax rate changes, we make a cumulative adjustment.

Our quarterly tax provision, and our quarterly estimate of our annual effective tax rate, is subject to significant variation due to several factors, including variability in accurately predicting our pre-tax and taxable income and loss and the mix of jurisdictions to which they relate, changes in how we do business, changes in law, regulations, and administrative practices, and relative changes of expenses or losses for which tax benefits are not recognized. Additionally, our effective tax rate can be more or less volatile based on the amount of pre-tax income. For example, the impact of discrete items and non-deductible expenses on our effective tax rate is greater when our pre-tax income is lower. The tax provision does not include any benefit for the federal research and development credit which expired at the end of 2013. If retroactively reinstated, the credit will be a discrete tax benefit in the period enacted.

We have tax deductions from stock-based compensation that exceed the stock-based compensation recorded for such instruments. To the extent such excess tax benefits are ultimately realized, they will increase shareholders’ equity. We utilize the with-and-without approach in determining if and when such excess tax benefits are realized, and under this approach excess tax benefits related to stock based compensation are the last to be realized.

Earnings per share
 
Basic earnings per share is computed by dividing net income attributable to common shares by the weighted average number of common shares outstanding during the period. Diluted earnings per share is computed by dividing net income attributable to common shares for the period by the weighted average number of common and potential common shares outstanding during the period. Potential common shares, comprising incremental common shares issuable upon the exercise of stock options and restricted stock awards are included in the calculation of diluted earnings per common share to the extent such shares are dilutive.


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The following table sets forth the computation of basic and diluted net income per common share for the periods indicated (in thousands, except per share data):
 
Three months ended March 31,
 
2014
 
2013
Net income attributable to common shares
$
3,970

 
$
7,697

Net income per common share—basic:
 

 
 

Net income attributable to common shares—basic
0.17

 
0.33

Weighted average common shares outstanding—basic
23,926

 
23,594

Effect of dilutive securities:
 

 
 

Stock options and restricted stock awards
413

 
422

Weighted average common shares outstanding—diluted
24,339

 
24,016

Net income attributable to common shares—diluted
$
0.16

 
$
0.32

 
The following shares were excluded from the calculation of diluted shares outstanding as their effect would have been anti-dilutive (in thousands):
 
Three months ended March 31,
 
2014
 
2013
Stock options and restricted stock units
226

 
575



3. RESTRUCTURING EXPENSE
 
During the fourth quarter of 2006, we began a facilities consolidation and restructuring program designed to reduce the overall expense structure in an effort to improve future operating performance. The facilities consolidation and restructuring program was substantially completed by the end of the second quarter of 2007.
 
Restructuring liabilities along with charges (credits) to expense and payments associated with the facilities consolidation and restructuring program are as follows (in thousands):
 
Balance at
12/31/2013
 
Accretion
Expense
 
Net Cash
Payments
 
Adjustments
 
Balance at
3/31/2014
Lease and contract termination costs
$
445

 
$
7

 
$
(92
)
 
$
(360
)
 
$

 
We reversed $360,000 and $432,000, respectively, of lease termination costs during the three months ended March 31, 2014 and 2013. These reversals were a result of our reoccupation of formerly restructured facility space. At March 31, 2014 our restructuring liability was zero.


4. BORROWINGS
 
U.S. Bank Financing Agreements
 
On December 26, 2012, we entered into a $3.0 million cash-collateralized line of credit agreement (the “Credit Agreement”) with U.S. Bank National Association (“U.S. Bank”) for the issuance of letters of credit. Advances under the Credit Agreement bear interest at one-month LIBOR plus 1.0%. The Credit Agreement matures on December 31, 2014. Amounts outstanding under the Credit Agreement were zero at March 31, 2014 and December 31, 2013.

At March 31, 2014 and December 31, 2013, letters of credit totaling $1.6 million were issued on our behalf collateralized by compensating cash balances held at U.S. Bank, which are included in Restricted cash in the accompanying consolidated balance sheets.
 
U.S. Bank Commercial Purchasing Card Agreement

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We have a commercial purchasing card (the “Purchasing Card”) agreement with U.S. Bank. We use the Purchasing Card for business purpose purchasing and must pay it in full each month. At March 31, 2014, $1.1 million was outstanding and $3.9 million was available under the Purchasing Card. At December 31, 2013, $517,000 was outstanding and $4.5 million was available under the Purchasing Card.

Capital leases

In March 2013, we entered into a capital lease arrangement for $2.6 million of computer equipment that will expire in 2017. We prepaid the entire $2.6 million shortly after entering into the agreement in order to obtain discounted pricing. As such, we have no future payment obligations under capital leases at March 31, 2014 and December 31, 2013.
 
Fixed assets included assets under capital leases of $4.2 million and accumulated depreciation related to assets under capital leases of $2.3 million and $2.1 million, respectively, at March 31, 2014 and December 31, 2013. Depreciation expense of assets recorded under capital leases was $160,000 and $1,000, respectively, for the three months ended March 31, 2014 and 2013.

5. COMMITMENTS AND CONTINGENCIES
 
Summary of future minimum lease payments for all operating leases
 
Minimum future payments under all operating leases as of March 31, 2014, are as follows (in thousands):
Payments due by period
 
 
2014 (remainder)
 
$
8,220

2015
 
10,272

2016
 
8,177

2017
 
4,203

2018
 
3,826

Thereafter
 
32,437

 
 
$
67,135

 
Rental expense for operating leases totaled $2.9 million and $2.1 million for the three months ended March 31, 2014 and 2013, respectively. There is no estimated sublease income expected over the next five years.

On March 6, 2014 we entered into amendments to extend the leases on our corporate headquarters and a data center space from their previous expiration of June 30, 2016 to January 31, 2017. The minimum future payments due under these amended operating leases are included in the summary of future minimum lease payments for all operating leases in the table above.
Naming rights
During 2011, we entered into a six-year agreement with the Oakland-Alameda County Coliseum Authority ("OACCA") for the right to name the Oakland Alameda County Coliseum. Amounts shown below represent annual payments due OACCA for the naming rights. We have the right to terminate this agreement at our sole option, subject to payment of a termination fee.
Minimum future payments under naming rights agreement as of March 31, 2014, are as follows (in thousands):
Payments due by period:
 
 
2014 (remainder)
 
$
1,311

2015
 
1,351

2016
 
1,391

Thereafter
 

 
 
$
4,053

Technology

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From time to time we enter into non-cancellable, long-term contractual agreements for technology services. Minimum future payments under these agreements as of March 31, 2014, are as follows (in thousands):
Payments due by period:
 
 
2014 (remainder)
 
$
4,252

2015
 
2,901

2016
 
1,683

Thereafter
 

 
 
$
8,836


Legal Proceedings
 
From time to time, we are involved in litigation concerning consumer protection, employment, intellectual property and other commercial matters related to the conduct and operation of our business and the sale of products on our Website. In connection with such litigation, we may be subject to significant damages. In some instances other parties may have contractual indemnification obligations to us. However, such contractual obligations may prove unenforceable or non-collectible, and in the event we cannot enforce or collect on indemnification obligations, we may bear the full responsibility for damages, fees and costs resulting from such litigation. We may also be subject to penalties and equitable remedies that could force us to alter important business practices. Such litigation could be costly and time consuming and could divert or distract our management and key personnel from our business operations. Due to the uncertainty of litigation and depending on the amount and the timing, an unfavorable resolution of some or all of these matters could materially affect our business, results of operations, financial position, or cash flows.
 
On February 2, 2007, along with five shareholder plaintiffs, we 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., and later amended the complaint to add Lehman Brothers Holdings Inc. as a defendant. The suit alleged that the defendants, who controlled 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 continued to cause dramatic declines in the share price of our stock and that the amount of “fails to deliver” often exceeded our entire supply of outstanding shares. The suit accused the defendants of violations of California securities laws and common law and violations of California’s Unfair Business Practices Act. After it filed for bankruptcy on September 2008, we elected not to pursue our claims against Lehman Brothers Holdings. On July 23, 2009, the court sustained defendants’ demurrer to our amended causes of action for conversion and trespass to chattels. On December 15, 2010, we and the other plaintiffs in the case entered into a settlement agreement with certain of the defendants requiring these defendants to pay in the aggregate $4.5 million to plaintiffs. Other terms of settlement are confidential. At that time, remaining defendants in the suit were Goldman Sachs Group, Inc., Goldman Sachs & Co., Goldman Sachs Execution & Clearing L.P., (“Goldman Defendants”) Merrill Lynch, Pierce, Fenner & Smith, Inc., Merrill Lynch Professional Clearing Corporation (“Merrill Lynch Defendants), and Bank of America Securities LLC. On December 15, 2010, we filed a motion to amend our complaint against the Goldman and Merrill Lynch Defendants to add a cause of action based on the New Jersey Racketeer Influenced and Corrupt Organization (RICO) Act. Defendants challenged the RICO claim by demurrer and eventually the court sustained the demurrer. We thereafter entered a settlement agreement with Bank of America Securities LLC, the terms of which are confidential, and have dismissed the action as to that defendant. On August 19, 2011, the remaining defendants filed a motion for summary judgment. On January 10, 2012, the court granted the motion for summary judgment as to all remaining defendants and the judgment has been entered. We have appealed that decision and each side has appealed the trial court’s decisions regarding sealing of certain records in the case. The defendants applied to the court for reimbursement from us of their allowable court costs in the collective amount of $2.4 million. We challenged the application, and the court reduced the amount to $689,471, which will be payable only if we do not succeed on our appeal of the summary judgment. The briefing of the appeals on both the records sealing and summary judgment is complete. The Court of Appeal has not set a date for oral argument. The nature of the loss contingencies relating to any court costs ordered against us are described above.
 
On September 23, 2009, SpeedTrack, Inc. sued us along with 27 other defendants in the United States District Court in the Northern District of California. We are alleged to have infringed a patent covering search and categorization software. We believe that certain third party vendors of products and services sold to us are contractually obligated to indemnify us in this action. On November 11, 2009, the parties stipulated to stay all proceedings in the case until resolution of a reexamination of

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the patent in question, and also until a previously filed infringement action against Wal-Mart Stores, Inc. and other retailers resulted either in judgment or dismissal. Subsequently, the parties agreed to extend the time for defendants’ complaint answer until 21 days following a court order to lift the stay to which the parties stipulated. The United States Patent and Trademark Office resolved the reexamination of the patent in question in favor of SpeedTrack, Inc. The case remains stayed, pending the outcome and appeal of the infringement action against Wal-Mart Stores, Inc. and other retailers. On February 22, 2012, the court in the Wal-Mart Stores case granted Wal-Mart Stores’ motion for summary judgment of non-infringement. The court also granted Speedtrack’s motion for summary judgment on patent validity. Speedtrack appealed, and the ruling was upheld. It is not known whether the summary judgments granted in the Wal-Mart Stores case will have an effect on the Speedtrack case in which we are named as one of the defendants. The nature of the loss contingencies relating to claims that have been asserted against us are described above. However no estimate of the loss or range of loss can be made. We intend to vigorously defend this action and pursue our indemnification rights with our vendors.

On September 29, 2010, a trustee in bankruptcy filed against us an adversary proceeding in the matter of In re: Petters Company, Inc., a case filed in United States Bankruptcy Court, in the District of Minnesota. The complaint alleges principal causes of action against us under various Bankruptcy Code sections and the Minnesota Fraudulent Transfer Act, to recover damages for alleged transfers of property from the Petters Company occurring prior to the filing of the case initially as a civil receivership in October 2008. The trustee’s complaint alleges such transfers occurred in at least one note transaction whereby we transferred at least $2.3 million and received in return transfers totaling at least $2.5 million. The trustee does not specify a date for the transactions; however we believe that any alleged transaction with the Petters Company would have taken place in excess of seven years from the date of the filing of the adversary proceeding. The case is in its discovery stages. We filed a motion to dismiss on statute of limitations and other grounds. The court consolidated the issues in our motion with issues raised by motion in similar trustee-filed cases. The court issued legal rulings on these consolidated legal issues, and has allowed portions of the case to proceed to the discovery stage. The nature of the loss contingencies relating to claims that have been asserted against us are described above. However, no estimate of the loss or range of loss can be made. We intend to vigorously defend this action.
 
On November 17, 2010, we were sued in the Superior Court of California, County of Alameda, by District Attorneys for the California Counties of Alameda, Marin, Monterey, Napa, Santa Clara, Shasta and Sonoma County, and the County of Santa Cruz later joined the suit. These district attorneys sought damages and an injunction under claims for violations of California consumer protection laws, alleging we made untrue or misleading statements concerning our pricing, price reductions, sources of products and shipping charges. The complaint asked for damages in the amount of not less than $15 million. We tried the case in September 2013 before the judge of the court and made final arguments in December 2013. On January 3, 2014, the court issued a tentative ruling in favor of the District Attorneys, which became a final Statement of Decision on February 5, 2014. The decision provides for an injunction that prescribes disclosures necessary for certain types of price advertising and price reductions and imposes civil penalties of $3,500 per day for practices from March 2006 through September 2008, and $2,000 per day for September 2008 through September 2013, totaling $6.8 million. The court issued a Final Judgment February 19, 2014 reflecting the Court’s Statement of Decision. We have stipulated to Plaintiff’s reimbursement of costs in the amount of $111,500. We have appealed the decision and have secured a bond as required in the ruling in the amount of 150% of the penalty imposed in the matter until the ruling on the appeal. The nature of the loss contingencies relating to claims that have been asserted against us are described above. We intend to continue to vigorously defend this action.
 
On September 11, 2011, Droplets, Inc. filed suit against us and eight other defendants in the United States District Court in the Eastern District of Texas for infringement of a patent covering strings of programming code downloaded from a server to a client computer. We have answered the complaint. The case is in its discovery stages and has been scheduled for trial in January 2015. The nature of the loss contingencies relating to claims that have been asserted against us are described above. However, no estimate of the loss or range of loss can be made. We intend to vigorously defend this action and pursue our indemnification rights with our vendors.
 
On September 13, 2011, Select Retrieval, LLC filed suit against us and 79 other defendants in the United States District Court for the District of Delaware for infringement of a patent covering the hierarchical display of interactive links on a webpage. We filed a motion to dismiss which was denied. The case is in its discovery stages. The nature of the loss contingencies relating to claims that have been asserted against us are described above. However, no estimate of the loss or range of loss can be made. We intend to vigorously defend this action and pursue our indemnification rights, if any, with our vendors.

On January 27, 2012, Pragmatus Telecom, LLC filed suit against us in the United States District Court for the District of Delaware for infringement of two patents covering a system for coordinating data and voice communications via customer contact channel changing system using voice over IP and infringement of one patent for coordinating data and voice

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communications via customer contact channel changing system. We answered the complaint. We tendered the defense of the case to an indemnitor. The case against us was stayed July 10, 2012, pending resolution of a declaratory judgment action filed by our indemnitor against Pragmatus. Our indemnitor reached a settlement agreement with Pragmatus, requiring no payment from us, and on February 7, 2014 the case was dismissed.
 
On March 1, 2012, H-W Technology, L.C. filed suit against us in the United States District Court in the Northern District of Texas for infringement of a patent entitled “Internet Protocol (IP) Phone with Search and Advertising Capability.” We answered the complaint. On January 28, 2013, we filed a motion for summary judgment for invalidity on two claims of the patent. On September 23, 2013, the court granted the motion. H-W Technology has appealed. We have applied to the court for court-ordered reimbursement of our legal fees and costs expended in our defense.
 
On May 2, 2012, Execware LLC filed suit against us in the United States District Court for the District of Delaware for infringement of a patent entitled: “Integrated Dialog Box for Rapidly Altering Presentation of Parametric Text Data Objects on a Computer Display.” We answered and defended the case. On March 7, 2014, Execware voluntarily dismissed the case.

On July 16, 2012, Digitech Image Technologies, LLC filed against us and 45 other defendants in the United States District Court for the Central District of California for infringement of a patent covering the imaging technology that facilitates prediction of color and location within digital cameras. The initial case was dismissed, but in September 2012, Digitech filed a new complaint on the same infringement claims. Subsequently, the court granted a motion for summary judgment on invalidity of the patent and entered judgment for us. Digitech has appealed. The appeal is in the briefing stages. The nature of the loss contingencies relating to claims that have been asserted against us are described above. However, no estimate of the loss or range of loss can be made. We intend to cooperate with our indemnitor and vigorously defend this action.
 
On July 19, 2012, Data Carriers, LLC filed suit against us in the United States District Court for the District of Delaware for infringement of a patent covering the “autocomplete” features of our website. We believe a third party vendor is contractually obligated to indemnify us in this action. We have answered the complaint. The case is in its discovery stages. The nature of the loss contingencies relating to claims that have been asserted against us are described above. However, no estimate of the loss or range of loss can be made. We intend to vigorously defend this action and pursue our indemnification rights with our vendors.
 
On February 11, 2013, RPost Holdings, Inc., RPost Communications Limited, and RMail Limited, filed suit against us in the United States District Court in Eastern District of Texas for infringement of patents covering products and services that verify the delivery and integrity of email messages. We tendered defense of the case to an indemnitor which accepted the defense. We have answered the complaint. The case is in its early stages. The nature of the loss contingencies relating to claims that have been asserted against us are described above. However, no estimate of the loss or range of loss can be made. We intend to vigorously defend this action and pursue our indemnification rights with our vendors.

On August 16, 2013, Online News Link LLC, filed suit against us in the United States District Court in District of Delaware for infringement of patents covering data distribution systems that can make downloading data fast and efficient. We are examining whether we are indemnified by any vendor. We were served with the complaint on August 19, 2013. We answered the complaint. The case is in its early stages. The nature of the loss contingencies relating to claims that have been asserted against us are described above. However, no estimate of the loss or range of loss can be made. We intend to vigorously defend this action and pursue any indemnification rights with our vendors.

On January 3, 2014, Guardian Media Technologies LTD filed suit against us in the United States District Court in the Eastern District of Texas for infringement of patents covering parental control features in DVD players and televisions. The suit relates to two prior lawsuits with Guardian filed in 2008, and in 2013, which were previously dismissed. We have requested indemnification from pertinent vendors. The case is in its early stages. The nature of the loss contingencies relating to claims that have been asserted against us are described above. However, no estimate of the loss or range of loss can be made. We intend to vigorously defend this action and pursue any indemnification rights with our vendors.
 
On September 30, 2013, Altaf Nazerali filed suit against us in the Supreme Court of British Columbia for vicarious liability for defamation, liable and slander. The suit relates to alleged representations about Nazerali found on the website www.deepcapture.com. The suit alleges that the representations were made by our Chief Executive Officer, Patrick Byrne, and two other employees. The case is in its early stages. The nature of the loss contingencies relating to claims that have been asserted against us are described above. However, no estimate of the loss or range of loss can be made.


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On February 7, 2014, Z-Dimensional, LLC filed suit against us in the United States District Court in the Eastern District of Texas for infringement of patents covering 3D Cameras. We have requested indemnification from pertinent vendors. The case is in its early stages. The nature of the loss contingencies relating to claims that have been asserted against us are described above. However, no estimate of the loss or range of loss can be made. We intend to vigorously defend this action and pursue any indemnification rights with our vendors.

In June of 2013, William French filed suit against us and 46 other defendants under seal in the Superior Court of the State of Delaware. The filing was unsealed on March 24, 2014. French brought the action on Delaware’s behalf for violations of Delaware’s unclaimed property laws and for recovery of the unredeemed gift card value allegedly attributable to Delaware residents. We have not been served. The case is in its early stages. The nature of the loss contingencies relating to claims that have been asserted against us are described above. However, no estimate of the loss or range of loss can be made.

We establish liabilities when a particular contingency is probable and estimable. At March 31, 2014, we have accrued $7.8 million in light of these probable and estimable liabilities. It is reasonably possible that the actual losses may exceed our accrued liabilities. We have other contingencies which are reasonably possible; however, the reasonably possible exposure to losses cannot currently be estimated.
 
6. INDEMNIFICATIONS AND GUARANTEES
 
During our normal course of business, we have made certain indemnities, commitments, and guarantees under which we 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 our directors and officers 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 we could be obligated to make. As such, we are unable to estimate with any reasonableness our potential exposure under these items. We have not recorded any liability for these indemnities, commitments, and guarantees in the accompanying consolidated balance sheets. We do, 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.
 
7. STOCK-BASED AWARDS
 
We have equity incentive plans that provide for the grant to employees of stock-based awards, including stock options and restricted stock. During the three months ended March 31, 2014, the Compensation Committee of the Board of Directors approved grants of 231,560 restricted stock awards, to our officers, board members and employees. The restricted stock awards vest over three years at 33.3% at the end of the first year, 33.3% at the end of the second year and 33.3% at the end of the third year and are subject to the employee’s continuing service to us. At March 31, 2014, there were 645,240 unvested restricted stock awards that remained outstanding.

The cost of restricted stock awards is determined using the fair value of our common stock on the date of the grant, and compensation expense is either recognized on a straight line basis over the three-year vesting schedule or on an accelerated schedule when vesting of restricted stock awards exceeds a straight-line basis. The cumulative amount of compensation expense recognized at any point in time is at least equal to the portion of the grant date fair value of the award that is vested at that date. The weighted average grant date fair value of restricted stock awards granted during the three months ended March 31, 2014 was $28.52.

Stock-based compensation expense related to restricted stock awards was $923,000 and $752,000 during the three months ended March 31, 2014 and 2013, respectively.


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The following table summarizes restricted stock award activity during the three months ended March 31, 2014 (in thousands):
 
Three months ended  
 March 31, 2014
 
 
 
Weighted Average
 
Units
 
Grant Date
Fair Value
Outstanding—beginning of year
704

 
$
10.79

Granted at fair value
232

 
28.52

Vested
(254
)
 
11.34

Forfeited
(37
)
 
14.05

Outstanding—end of period
645

 
$
16.73

 
8. BUSINESS SEGMENTS
 
Segment information has been prepared in accordance with ASC Topic 280 Segment Reporting. Segments were determined based on how we manage the business. There were no inter-segment sales or transfers during the three months ended March 31, 2014 and 2013. We evaluate the performance of our segments and allocate resources to them based primarily on gross profit. The table below summarizes information about reportable segments for the three months ended March 31, 2014 and 2013 (in thousands):
 
Three months ended  
 March 31,
 
 
 
Fulfillment
 
 
 
Direct
 
partner
 
Total
2014
 

 
 

 
 

Revenue, net
$
38,047

 
$
303,160

 
$
341,207

Cost of goods sold
33,097

 
244,114

 
277,211

Gross profit
$
4,950

 
$
59,046

 
$
63,996

Operating expenses
 

 
 

 
57,929

Other income, net
 

 
 

 
493

Provision for income taxes
 

 
 

 
2,590

Net income
 

 
 

 
$
3,970

 
 
 
 
 
 
2013
 

 
 

 
 

Revenue, net
$
41,942

 
$
270,052

 
$
311,994

Cost of goods sold
37,149

 
215,909

 
253,058

Gross profit
$
4,793

 
$
54,143

 
$
58,936

Operating expenses
 

 
 

 
51,521

Other income, net
 

 
 

 
328

Provision for income taxes
 

 
 

 
46

Net income
 

 
 

 
$
7,697

 
The direct segment includes revenues, direct costs, and cost allocations associated with sales fulfilled from our warehouses. Costs for this segment include product costs, 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 sales fulfilled from warehouses maintained by our fulfillment partners. Costs for this segment include product costs, outbound freight and fulfillment costs, credit card fees and customer service costs.
 
Assets have not been allocated between the segments for our internal management purposes and, as such, they are not presented here.


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For the three months ended March 31, 2014 and 2013, substantially all sales revenues were attributable to customers in the United States. At March 31, 2014 and December 31, 2013, substantially all of our fixed assets were located in the United States.

9. SUBSEQUENT EVENTS
 
Subsequent to the balance sheet date of March 31, 2014, the board of directors authorized management to pursue due diligence, finalize terms and enter into an agreement to purchase land in connection with the possible construction of our future headquarters. While we have reached an agreement in principle to purchase such land, we have not yet executed the agreement which is subject to our due diligence and final negotiation of terms. If we proceed to develop a facility for our new headquarters, we will need to obtain additional financing. We are unable to estimate the potential financial effect of the agreement to purchase land, or the subsequent transaction to lease or develop a facility for our new headquarters until more definitive terms are known.

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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
 
Special Note Regarding Forward-Looking Statements
 
This Quarterly Report on Form 10-Q and the documents incorporated herein by reference, as well as our other public documents and statements our officers and representatives may make from time to time, contain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. These statements are therefore entitled to the protection of the safe harbor provisions of these laws. These forward-looking statements involve risks and uncertainties, and relate to future events or our future financial or operating performance. The forward-looking statements include all statements other than statements of historical fact, including, without limitation, all statements regarding:

the anticipated benefits and risks of our business and plans;
our ability to attract and retain customers in a cost-efficient manner;    
the effectiveness of our marketing;    
our future operating and financial results, including any projections of revenue, capital expenditures or other financial measures or amounts;    
our decision to accept bitcoins as an acceptable payment for the goods and services we sell and our expectations regarding the advantages and risks of doing so, and our expectations that Coinbase.com and any other bitcoin transaction processing agents we utilize will perform in accordance with our expectations regardless of fluctuations in the value of bitcoin or other developments that may affect us or such processing agents;     
our decision to acquire and hold bitcoins and our expectations regarding the advantages and risks of doing so;    
the competition we currently face and will face in our business as the ecommerce business continues to become more competitive and additional competitors, including competitors based in China or elsewhere, continue to increase their efforts in our primary markets;    
the effects of government regulation;    
our future capital requirements and our ability to satisfy our capital needs;    
our expectations regarding the adequacy of our liquidity;    
our ability to retire or refinance any debt we may have;    
our plans for international markets, our expectations for our international sales efforts and the anticipated results of our international operations;    
our plans for changes to our business;    
our beliefs regarding current or future litigation or regulatory actions;    
our beliefs regarding the costs and benefits of our “spend and defend” policy under which we generally refuse to settle abusive patent suits brought against us;    
our beliefs and expectations regarding existing and future tax laws and related laws and the application of those laws to our business;    
our beliefs regarding the adequacy of our insurance coverage;    
our beliefs regarding the adequacy and anticipated functionality of our infrastructure, including our backup facilities and beliefs regarding the adequacy of our disaster planning and our ability to recover from a disaster or other interruption of our ability to operate our website at its highest level of functionality;    
our beliefs regarding our cybersecurity efforts and measures and the costs we will incur in our ongoing efforts to avoid interruptions to our product offerings and other business processes from cyber attacks;    
our belief that we can meet our published product shipping standards even during periods of relatively high sales activity;    
our belief that we can maintain or improve upon customer service levels that we and our customers consider acceptable;    
our beliefs regarding the adequacy of our order processing systems and our fulfillment and distribution capabilities;    
our beliefs and expectations regarding the adequacy of our office and warehouse facilities and any additional or modified office or warehouse facilities;    
our expectations regarding the costs and benefits of our other businesses including our car listing service, our Worldstock Fair Trade offerings, our Main Street Revolution offerings, our consignment services, our ecommerce marketplace channel offerings, our community site, our recently-announced public service pet

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adoption program, and future other businesses and the anticipated functionality and results of operations of them;
our expectations regarding the costs and benefits of various programs we offer, including Club O and programs pursuant to which we offer free or discounted participation in Club O or other programs we offer to members of the United States Armed Forces and/or to full-time, post-secondary students or others;     
our belief that we and our fulfillment partners will be able to maintain inventory levels at appropriate levels despite the seasonal nature of our business;    
our belief that our sales through other ecommerce marketplace channels will be successful and will become an important part of our business; and    
our belief that we can successfully offer and sell a constantly changing mix of products and services.

Further, in some cases, you can identify forward-looking statements by terminology such as may, will, could, should, likely, expect, plan, seek, intend, anticipate, project, believe, estimate, predict, potential, goal, strategy, future or continue, the negative of such terms or other comparable terminology. These statements are only predictions. Actual events or results may differ materially from those contemplated by forward-looking statements for a variety of reasons, including among others:

changes in U.S. and global economic conditions and consumer spending;
world events;
the rate of growth of the Internet and online commerce, and the occurrence of any event that would discourage or prevent consumers from shopping online;
any failure to maintain our existing relationships or build new relationships with fulfillment partners on acceptable terms;
any difficulties we may encounter maintaining optimal levels of product quality and selection or in attracting sufficient consumer interest in our product offerings;
modifications we may make to our business model from time to time, including aspects relating to our product mix and the mix of direct/fulfillment partner sourcing of the products we offer;
the mix of products purchased by our customers;
problems with cyber security or data breaches or the costs of preventing or responding to any such problems;
problems with or affecting our credit card processors, including cyber-attacks, Internet or other infrastructure or communications impairment or other events that could interrupt the normal operation of the credit card processors;
problems with the facility where substantially all of our computer and communications hardware is located or other problems that result in the unavailability of our Website or reduced performance of our transaction systems;
difficulties we may have in responding to technological changes;
problems with the large volume of fraudulent purchase orders we receive on a daily basis;
problems we may encounter as a result of the listing or sale of pirated, counterfeit or illegal items by third parties;
difficulties we may have financing our operations or our expansion with either internally generated funds or external sources of financing;
the extent to which we owe income or sales taxes or are required to collect sales taxes or report sales or to modify our business model in order to avoid being required to collect sales taxes or report sales;
any difficulties we may encounter as a consequence of accepting or holding bitcoins, whether as a result of regulatory, tax or other legal issues, technological issues, value fluctuations, lack of widespread adoption of bitcoins as an acceptable medium of exchange or otherwise;
competition, including competition from well-established competitors including Amazon.com, and from others including competitors with business models that may include delivery capabilities that we may be unable to match;
difficulties with the management of our growth and any periods in which we fail to grow in accordance with our plans;
fluctuations in our operating results;
our efforts to expand internationally;
our efforts to offer additional services to our customers, including insurance products and consumer financing;    
the outcomes of legal proceedings, investigations and claims, including the outcome of the lawsuit and judgment against us obtained by the District Attorneys of a number of California counties as described in this report;
our inability to optimize our warehouse operations;

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risks of inventory management and seasonality; and
the other risks described in this report or in our other public filings.
    
In evaluating all forward-looking statements, you should specifically consider the risks outlined above and in this Form 10-Q in Part II, Item 1A under the caption “Risk Factors” and elsewhere in this report. These factors may cause our actual results to differ materially from those contemplated by any forward-looking statement. Although we believe that the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee or offer any assurance of future results, levels of activity, performance or achievements or other future events.

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 or any changes in our expectations or any change in any events, conditions or circumstances on which any of our forward-looking statements are based.
 
Available Information
 
Our Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and other reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 are available free of charge through the Investors Relations section of our main website www.overstock.com as soon as reasonably practicable after we electronically file such material with, or furnish it to, the Securities and Exchange Commission. Our Internet Website and the information contained therein or connected thereto are not a part of or incorporated into this Quarterly Report on Form 10-Q.
 
Overview
 
We are an online retailer offering discount brand name, non-brand name and closeout merchandise, including furniture, home decor, bedding and bath, housewares, jewelry and watches, apparel and designer accessories, electronics and computers, and sporting goods, among other products. We sell hundreds of thousands of best seller and current run books, magazines, CDs, DVDs and video games (“BMMG”). We sell these products and services through our Internet websites located at www.overstock.com, www.o.co and www.o.biz (“Website”). Although our three websites are located at different domain addresses, the technology and equipment and processes supporting the Website and the process of order fulfillment described herein are the same for all three websites.
 
Our company, based in Salt Lake City, Utah, was founded in 1997. We launched our initial website in March 1999. Our Website offers our customers an opportunity to shop for bargains conveniently, while offering our suppliers an alternative inventory liquidation or sales channel. We continually add new, and sometimes limited, inventory to our Website in order to create an atmosphere that encourages customers to visit frequently and purchase products before our inventory sells out. We sell products primarily in the United States.

As used herein, “Overstock,” “Overstock.com,”, “O.co,” “we,” “our” and similar terms include Overstock.com, Inc. and its subsidiaries, unless the context indicates otherwise.

Executive Commentary
 
This executive commentary is intended to provide investors with a view of our business through the eyes of our management. As an executive commentary, it necessarily focuses on selected aspects of our business. This executive commentary is intended as a supplement to, but not a substitute for, the more detailed discussion of our business included elsewhere herein. Investors are cautioned to read our entire “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” as well as our interim and audited financial statements, and the discussion of our business and risk factors and other information included elsewhere or incorporated in this report. This executive commentary includes forward-looking statements, and investors are cautioned to read the “Special Note Regarding Forward-Looking Statements” at the beginning of Item 2, “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

Revenues in Q1 2014 increased 9% compared to Q1 2013. The growth in revenue was primarily due to an 8% increase in average order size, from $153 to $165, coupled with a 5% increase in orders. These increases were partially offset by an increase in the amount of orders taken but not delivered at quarter end due to higher average daily sales in the last week of the quarter and the timing of quarter end. Although our average order size has increased in recent years, we expect the rate of increase to taper in 2014. Additionally, we continue to experience increased customer visits and revenues originating from mobile devices.

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Gross profit in Q1 2014 increased 9% compared to Q1 2013 primarily as a result of that revenue growth. Gross margin decreased slightly to 18.8% in Q1 2014 compared to 18.9% in Q1 2013. The decrease in gross margin was largely due to increased promotional activities including coupons, site sales, and Club O rewards, which are recognized as a reduction of revenue.
 
Sales and marketing expenses as a percentage of revenue increased from 6.0% to 6.9% during Q1 2014 as compared to Q1 2013, primarily due to increased spending in the sponsored search marketing channel due to driving a higher proportion of our revenue through that channel, and from increased staff-related costs. During December 2013, we increased our marketing spending as a result of softer sales observed during the last several weeks of the year. As a result of improved marketing performance during Q1 2014, our sales and marketing as a percentage of net revenues decreased from 7.9% during Q4 2013 to 6.9% during Q1 2014.

As a result of these factors, we had a 1% increase in Contribution during Q1 2014 as compared to Q1 2013 (see “Non-GAAP Financial Measures” below for a reconciliation of Contribution to Gross Profit). Contribution margin was 11.9% for Q1 2014 and 12.9% for Q1 2013.

Technology expenses in Q1 2014 increased $1.4 million compared to Q1 2013, primarily due to an increase in staff-related and external contractor costs. We continue to seek opportunities for growth in our business, including expanding our international sales and our distribution capabilities. We also intend to begin to broker insurance products, and offer consumer financing products through a third party, to our customers in 2014. As a result, we expect to continue to increase our technology expenses to support these initiatives, and these expenses may be material.

General and administrative expense in Q1 2014 increased $208,000 compared to Q1 2013 primarily due to a $1.6 million increase in staff-related costs and professional fees, largely offset by a $777,000 decrease in legal costs and a $680,000 decrease in our estimate of legal loss contingencies.

We have reached agreements in principle to purchase land in Salt Lake City, Utah and develop our future headquarters on the site. Both agreements are non-binding and subject to our due diligence and final negotiation of terms. If we proceed to develop a facility for our new headquarters, we will need to obtain additional financing. The lease on our current headquarters expires in 2017.
 
The balance of our Management’s Discussion and Analysis of Financial Condition and Results of Operations provides further information about the matters discussed above and other important matters affecting our business.

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Results of Operations
 
The following table sets forth our results of operations expressed as a percentage of total net revenue:
 
 
Three months ended  
 March 31,
 
 
2014
 
2013
 
 
(as a percentage of total net
revenue)
Revenue, net
 
 

 
 

Direct
 
11.2
 %
 
13.4
 %
Fulfillment partner
 
88.8

 
86.6

Total net revenue
 
100.0

 
100.0

Cost of goods sold
 
 
 
 
Direct
 
9.7

 
11.9

Fulfillment partner
 
71.5

 
69.2

Total cost of goods sold
 
81.2

 
81.1

Gross profit
 
18.8

 
18.9

Operating expenses:
 
 
 
 
Sales and marketing
 
6.9

 
6.0

Technology
 
5.7

 
5.8

General and administrative
 
4.5

 
4.8

Restructuring
 
(0.1
)
 
(0.1
)
Total operating expenses
 
17.0

 
16.5

Operating income
 
1.8

 
2.4

Interest income
 

 

Interest expense
 

 

Other income, net
 
0.1

 
0.1

Net income before income taxes
 
1.9

 
2.5

Provision for income taxes
 
0.8

 

Net income
 
1.2
 %
 
2.5
 %
 
Comparisons of Three Months Ended March 31, 2014 to Three Months Ended March 31, 2013
 
Revenue
 
The following table reflects our net revenues for the three months ended March 31, 2014 and 2013 (in thousands):
 
 
Three months ended  
 March 31,
 
 
 
 
 
 
2014
 
2013
 
$ Change
 
% Change
Revenue, net
 
 

 
 

 
 

 
 

Direct
 
$
38,047

 
$
41,942

 
$
(3,895
)
 
(9.3
)%
Fulfillment partner
 
303,160

 
270,052

 
33,108

 
12.3
 %
Total revenue, net
 
$
341,207

 
$
311,994

 
$
29,213

 
9.4
 %
 
The primary reason for increased total net revenue for the three months ended March 31, 2014 was an increase of 8% in average order size, from $153 to $165, coupled with a 5% increase in orders. These increases were partially offset by an increase in the amount of orders taken but not delivered at quarter end due to higher average daily sales in the last week of the quarter and the timing of quarter end. Although our average order size has increased in recent years, we expect the rate of increase to taper in 2014. Additionally, we continue to experience increased customer visits and revenues originating from mobile devices.
 

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The primary reason for decreased direct revenue for the three months ended March 31, 2014 was a decrease in sales of clothing and shoes due to a shift from a direct inventory-based model to a fulfillment partner-based model to reduce exposure from seasonal inventory and markdowns.
 
The increase in fulfillment partner revenue for the three months ended March 31, 2014 was primarily due to an increase in sales of home and garden products. We do not expect the sales mix shift to home and garden products to continue at the same rate in 2014 as in recent years.

The shift of business from direct to fulfillment partner (or vice versa) is an economic decision based on the economics of each particular product offering at the time and we generally do not have particular goals for an “appropriate” mix or percentage for the size of either. We believe that the mix of the business between direct and fulfillment partner is consistent with our strategic objectives for our business model in the current economic environment and we do not currently foresee any material shifts in mix.

We continue to seek increased participation in our Club O loyalty program as sales growth from customers with Club O memberships is typically higher than from other customers. For additional information regarding our Club O loyalty program see Item 1 of Part I, “Financial Statements (Unaudited)” -Note 2 -“Accounting Policies” under the section “Club O loyalty program.”
  
International sales were approximately 1.5% of total net revenues for the three months ended March 31, 2014 and 2013.
 
Change in estimate of average transit times (days)
 
Revenue related to merchandise sales is recognized upon delivery to our customers. As we ship high volumes of packages through multiple carriers, it is not practical for us to track the actual delivery date of each shipment. Therefore, we use estimates to determine which shipments are delivered and, therefore, recognized as revenue at the end of the period. Our delivery date estimates are based on average shipping transit times. We review and update our estimates on a quarterly basis based on our actual transit time experience. However, actual shipping times may differ from our estimates.
 
The following table shows the effect that hypothetical changes in the estimate of average shipping transit times would have had on the reported amount of revenue and net income for the three months ended March 31, 2014 (in thousands):
 
 
 
Three Months Ended 
 March 31, 2014
Change in the
Estimate of Average
Transit Times (Days)
 
 
Increase
(Decrease)
Revenue
 
Increase
(Decrease) Net
Income
2
 
 
$
(10,137
)
 
$
(1,475
)
1
 
 
$
(4,238
)
 
$
(626
)
As reported
 
 
 As reported

 
 As reported

-1
 
 
$
3,855

 
$
567

-2
 
 
$
7,414

 
$
1,087

 
See “Executive Commentary” above for additional discussion regarding revenue.
 
Gross profit and gross margin
 
Our overall gross margins fluctuate based on our sales volume mix between our direct business and fulfillment partner business; changes in vendor and / or customer pricing, including competitive pricing; inventory management decisions within the direct business; sales coupons and promotions; product mix of sales; and operational and fulfillment costs.
 






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The following table reflects our net revenues, cost of goods sold and gross profit for the three months ended March 31, 2014 and 2013 (in thousands):
 
 
Three months ended  
 March 31,
 
 
 
 
 
 
2014
 
2013
 
$ Change
 
% Change
Revenue, net
 
 

 
 

 
 

 
 

Direct
 
$
38,047

 
$
41,942

 
$
(3,895
)
 
(9.3
)%
Fulfillment partner
 
303,160

 
270,052

 
33,108

 
12.3
 %
Total net revenues
 
$
341,207

 
$
311,994

 
$
29,213

 
9.4
 %
Cost of goods sold
 
 

 
 

 
 

 
 

Direct
 
$
33,097

 
$
37,149

 
$
(4,052
)
 
(10.9
)%
Fulfillment partner
 
244,114

 
215,909

 
28,205

 
13.1
 %
Total cost of goods sold
 
$
277,211

 
$
253,058

 
$
24,153

 
9.5
 %
Gross Profit
 
 

 
 

 
 

 
 

Direct
 
$
4,950

 
$
4,793

 
$
157

 
3.3
 %
Fulfillment partner
 
59,046

 
54,143

 
4,903

 
9.1
 %
Total gross profit
 
$
63,996

 
$
58,936

 
$
5,060

 
8.6
 %


Gross margins for the past five quarterly periods and fiscal year ending 2013 were:
 
 
Q1 2013
 
Q2 2013
 
Q3 2013
 
Q4 2013
 
FY 2013
 
Q1 2014
Direct
 
11.4
%
 
12.2
%
 
13.7
%
 
13.4
%
 
12.7
%
 
13.0
%
Fulfillment Partner
 
20.0
%
 
20.8
%
 
20.4
%
 
18.6
%
 
19.8
%
 
19.5
%
Combined
 
18.9
%
 
19.7
%
 
19.6
%
 
18.0
%
 
19.0
%
 
18.8
%

The increase in direct gross margin for the three months ended March 31, 2014 when compared to the same period in 2013 is primarily due to a continued shift in sales mix into higher margin home and garden products partially offset by higher warehousing costs.

The decrease in fulfillment partner gross margin for the three months ended March 31, 2014 as compared to the same period in 2013 was largely due to increased promotional activities including coupons, site sales, and Club O rewards, which are recognized as a reduction of revenue.
 
Cost of goods sold includes stock-based compensation expense of $40,000 and $48,000 for the three months ended March 31, 2014 and 2013, respectively.
 
See “Executive Commentary” above for additional discussion.

Fulfillment costs

Fulfillment costs include all warehousing costs, including fixed overhead and variable handling costs (excluding packaging costs), as well as credit card fees and customer service costs, all of which we include as costs in calculating gross margin. We believe that some companies in our industry, including some of our competitors, account for fulfillment costs within operating expenses, and therefore exclude fulfillment costs from gross margin. As a result, our gross margin may not be directly comparable to others in our industry.
 

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The following table has been included to provide investors additional information regarding our classification of fulfillment costs, gross profit and margin, thus enabling investors to better compare our gross margin with others in our industry (in thousands):
 
 
Three months ended  
 March 31,
 
 
2014
 
2013
Total revenue, net
 
$
341,207

 
100%
 
$
311,994

 
100%
Cost of goods sold
 
 

 
 
 
 

 
 
Product costs and other cost of goods sold
 
261,798

 
77%
 
239,197

 
77%
Fulfillment and related costs
 
15,413

 
5%
 
13,861

 
4%
Total cost of goods sold
 
277,211

 
81%
 
253,058

 
81%
Gross profit
 
$
63,996

 
19%
 
$
58,936

 
19%
 
Fulfillment costs as a percentage of sales may vary due to several factors, such as our ability to manage costs at our warehouses, significant changes in the number of units received and fulfilled, the extent to which we use third party fulfillment services and warehouses, and our ability to effectively manage customer service costs and credit card fees. Fulfillment and related costs remained relatively flat during the three months ended March 31, 2014 as compared to the same periods in 2013 with a slight increase due to additional warehousing costs.
 
See “Gross profit” above for additional discussion.
 
Operating expenses
 
Sales and marketing expenses
 
We advertise through a number of targeted online marketing channels, such as sponsored search, affiliate marketing, portal advertising, e-mail campaigns, and other initiatives. We also use nationwide television, print and radio advertising campaigns to promote sales.

The following table reflects our sales and marketing expenses for the three months ended March 31, 2014 and 2013 (in thousands):
 
 
Three months ended  
 March 31,
 
 
 
 
 
 
2014
 
2013
 
$ Change
 
% Change
Sales and marketing expenses
 
$
23,392

 
$
18,705

 
$
4,687

 
25.1
%
Sales and marketing expenses as a percent of net revenues
 
6.9
%
 
6.0
%
 
 
 
 
 
The $4.7 million increase in sales and marketing expenses for the three months ended March 31, 2014, as compared to the same period in 2013, was primarily due to increased spending in the sponsored search marketing channel due to driving a higher proportion of our revenue through that channel, and from increased staff-related costs.
 
Sales and marketing expenses include stock-based compensation expense of $81,000 and $25,000 for the three months ended March 31, 2014 and 2013, respectively.

Costs associated with our discounted shipping and other promotions, such as coupons, site sales, and Club O rewards, are not included in marketing expense. Rather, they are accounted for as a reduction of revenue and therefore affect revenues and gross margin. We consider discounted shipping and other promotions, such as our policy of free shipping on orders over $50 introduced in early January 2013, as an effective marketing tool, and intend to continue to offer them as we deem appropriate as part of our overall marketing plan.

Technology expenses
 
We seek to invest efficiently in technology, including web services, customer support solutions, website search, expansion of new and existing product categories, and in investments in technology to enhance the customer experience, improve our process efficiency and support our logistics infrastructure. We continue to seek opportunities for growth in our

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business, including expanding our international sales and our distribution capabilities. We also intend to begin to broker insurance products, and offer consumer financing products through a third party, to our customers in 2014. As a result, we expect to continue to increase our technology expenses to support these initiatives, and these expenses may be material.

The following table reflects our technology expenses for the three months ended March 31, 2014 and 2013 (in thousands):
 
 
Three months ended  
 March 31,
 
 
 
 
 
 
2014
 
2013
 
$ Change
 
% Change
Technology expenses
 
$
19,601

 
$
18,160

 
$
1,441

 
7.9
%
Technology expenses as a percent of net revenues
 
5.7
%
 
5.8
%
 
 

 
 

 
The $1.4 million increase in technology costs for the three months ended March 31, 2014, is primarily due to an increase in staff related and external contractor costs.
 
Technology expenses include stock-based compensation expense of $170,000 and $124,000 for the three months ended March 31, 2014 and 2013, respectively.
 
General and administrative expenses
 
The following table reflects our general and administrative expenses for the three months ended March 31, 2014 and 2013 (in thousands):
 
 
Three months ended  
 March 31,
 
 
 
 
 
 
2014
 
2013
 
$ Change
 
% Change
General and administrative expenses
 
$
15,296

 
$
15,088

 
$
208

 
1.4
%
General and administrative expenses as a percent of net revenues
 
4.5
%
 
4.8
%
 
 

 
 


The $208,000 increase in general and administrative expenses (“G&A”) for the three months ended March 31, 2014, is primarily due to a $1.6 million increase in staff-related costs and professional fees, largely offset by a $777,000 decrease in legal costs and a $680,000 decrease in our estimate of legal loss contingencies.

G&A expenses include stock-based compensation expense of approximately $632,000 and $555,000 for the three months ended March 31, 2014 and 2013, respectively.

Restructuring
 
During the three months ended March 31, 2014 and 2013 we reversed $360,000 and $432,000, respectively, of lease termination costs. These reversals were a result of our reoccupation of formerly restructured facility space. At March 31, 2014 our restructuring liability was zero.
 
Depreciation expense
 
Depreciation expense is classified within the corresponding operating expense categories on the consolidated statements of operations as follows (in thousands):
 
 
Three months ended  
 March 31,
 
 
2014
 
2013
Cost of goods sold - direct
 
$
87

 
$
104

Technology
 
3,437

 
3,416

General and administrative
 
271

 
343

Total depreciation and amortization, including internal-use software and website development
 
$
3,795

 
$
3,863

 

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Non-operating income (expense)
 
Interest income
 
Our interest income is primarily derived from the investment of our cash in cash equivalents and short-term investments. Interest income for the three months ended March 31, 2014 and 2013 totaled $41,000 and $34,000, respectively.
 
Interest expense
 
Our interest expense is primarily derived from interest incurred on our line of credit and our restructuring accrual. Interest expense for the three months ended March 31, 2014 and 2013 totaled $7,000 and $51,000, respectively, decreasing primarily as a result of the elimination of the restructuring accrual.

Other income, net
 
Other income, net for the three months ended March 31, 2014 increased to $459,000 from $345,000 in 2013 primarily due to increased gift card breakage.

Income taxes
 
Our provision for income taxes for the three months ended March 31, 2014 and 2013 was $2.6 million and $46,000, respectively. The increase is primarily due to our deferred tax asset valuation release in 2013. At March 31, 2014 and December 31, 2013 we had federal net operating loss carry forwards of approximately $145.6 million and $152.2 million, respectively, and state net operating loss carry forwards of approximately $135.0 million and $141.2 million, respectively, which may be used to offset future taxable income. Our net operating loss carry forwards will begin to expire in 2020 to 2031 if unused.

Seasonality
 
Based upon our historical experience, revenue typically increases during the fourth quarter because of the holiday retail season and gross margin decreases due to increased sales of certain lower margin products, such as electronics. The actual quarterly results for each quarter could differ materially depending upon consumer preferences, availability of product and competition, among other risks and uncertainties. Accordingly, there can be no assurances that seasonal variations will not materially affect our results of operations in the future.
 
The following table reflects our total net revenues for each of the quarters in 2014, 2013 and 2012 (in thousands):
 
 
First
Quarter
 
Second
Quarter
 
Third
Quarter
 
Fourth
Quarter
2014
 
$
341,207

 
$
N/A

 
$
N/A

 
$
N/A

2013
 
 
311,994

 
 
293,204

 
 
301,426

 
 
397,593

2012
 
 
262,367

 
 
239,536

 
 
255,352

 
 
342,034

 
Liquidity and Capital Resources
 
Current sources of liquidity
 
While we believe that the cash and cash equivalents currently on hand and expected cash flows from future operations will be sufficient to continue operations for at least the next twelve months; we may require additional financing. Although we may attempt to obtain additional financing, there can be no assurance that we will be able to do so. There can be no assurance that if additional financing is necessary it will be available, or, if available, that such financing can be obtained on satisfactory terms. Our failure to generate sufficient revenues or profits or to obtain additional financing or raise additional capital could have a material adverse effect on our operations and on our ability to achieve our intended business objectives. Any projections of future cash needs and cash flows are subject to substantial uncertainty.

We have reached agreements in principle to purchase land in Salt Lake City, Utah and develop our future headquarters on the site. Both agreements are non-binding and subject to our due diligence and final negotiation of terms. If we proceed to develop a facility for our new headquarters, we will need to obtain additional financing. The lease on our current headquarters expires in 2017.

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Our principal sources of liquidity are cash flows generated from operations, and our existing cash and cash equivalents. At March 31, 2014, our only available credit facility was a $3.0 million facility solely to support letters of credit. At March 31, 2014, we had cash and cash equivalents of $110.6 million.
 
Cash flow information is as follows (in thousands):
 
 
Three months ended  
 March 31,
 
Twelve months ended 
 March 31,
 
 
2014
 
2013
 
2014
 
2013
Cash provided by (used in):
 
 

 
 

 
 

 
 

Operating activities
 
$
(29,679
)
 
$
(1,653
)
 
$
55,619

 
$
48,726

Investing activities
 
(6,152
)
 
(5,985
)
 
(26,167
)
 
(17,701
)
Financing activities
 
(2,187
)
 
(4,014
)
 
(700
)
 
(21,235
)
 
Free Cash Flow
 
“Free Cash Flow” (a non-GAAP measure) for the three months ended March 31, 2014 and 2013, was $(35.9) million and $(7.7) million, respectively, and $37.4 million and $32.3 million for the twelve months ended March 31, 2014 and 2013, respectively. See “Non-GAAP Financial Measures” below for a reconciliation of Free Cash Flow to net cash provided by (used in) operating activities.

Cash flows from operating activities
 
For the three months ended March 31, 2014 and 2013, our operating activities resulted in a net cash outflow of $29.7 million and $1.7 million, respectively.
 
Cash received from customers generally corresponds to our net revenues as our customers primarily use credit cards to buy from us causing our receivables from these sales transactions to settle quickly. We have payment terms with our fulfillment partners that generally extend beyond the amount of time necessary to collect proceeds from our customers. As a result, following our typically seasonally strong fourth quarter sales, at December 31 of each year, our cash, cash equivalents and accounts payable balances normally reach their highest level (other than as a result of cash flows provided by or used in investing and financing activities). However, our accounts payable balance normally declines during the first three months following year-end, which normally results in a decline in our cash and cash equivalents balances from the year-end balance. The seasonality of our business causes payables and accruals to grow significantly in the fourth quarter, and then decrease in the first quarter when they are typically paid.
 
The $29.7 million of net cash used by operating activities during the three months ended March 31, 2014 was due to decreases in accounts payable of $31.9 million and accrued liabilities of $13.7 million. Accounts payable increased in Q4 2013 due to increased sales and in part due to the timing of key holiday sales. In 2013, the holiday sales season began later than in previous years, and as a result some of our payments to our suppliers for holiday sales were due in January 2014 rather than in December 2013. This caused a significant increase in accounts payable during Q4 2013 and a significant decrease in accounts payable during Q1 2014. Accrued liabilities increased during Q4 2013 due to the timing of some invoices related to marketing expenses and legal matters which were paid in Q1 2014. The net cash used by operating activities during the three months ended March 31, 2014 was partially offset by a reduction in inventory of $4.3 million, net income of $4.0 million, and non-cash depreciation, amortization and stock compensation expense of $4.7 million.

The $1.7 million of net cash used in operating activities during the three months ended March 31, 2013 was primarily for payments of accounts payable of $15.7 million following the holiday season and a decrease in deferred revenue of $6.9 million, partially offset by a combined increase in inventory and accounts receivable of $8.4 million, net income of $7.7 million, and non-cash depreciation, amortization and stock compensation expense of $4.6 million.
 
Cash flows from investing activities
 
Cash provided by investing activities primarily corresponds with expenditures for fixed assets, including internal-use software and website development costs, purchases, sales and maturities of marketable securities, and investments in precious

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metals. For the three months ended March 31, 2014, investing activities resulted in net cash outflows of $6.2 million, primarily from expenditures for fixed assets. For the three months ended March 31, 2013 investing activities resulted in net cash outflows of $6.0 million, resulting primarily from expenditures for fixed assets.
 
Cash flows from financing activities
 
For the three months ended March 31, 2014 and 2013, financing activities resulted in net cash outflows of $2.2 million and $4.0 million, respectively.
 
The $2.2 million used in financing activities during the three months ended March 31, 2014 resulted primarily from $2.3 million for the purchase of shares of our common stock withheld for minimum tax withholdings upon the vesting of a portion of certain restricted stock award grants.
 
The $4.0 million used in financing activities during the three months ended March 31, 2013 resulted primarily from $2.6 million for prepayment of capital leases for computer equipment and $1.4 million for the purchase of shares of our common stock withheld for minimum tax withholdings upon the vesting of a portion of certain restricted stock award grants.
 
Contractual Obligations and Commitments
 
The following table summarizes our contractual obligations as of March 31, 2014 and the effect such obligations and commitments are expected to have on our liquidity and cash flow in future periods (in thousands):
 
 
 
Payments Due by Period
Contractual Obligations
 
Remainder
of 2014
 
2015
 
2016
 
2017
 
2018
 
Thereafter
 
Total
Operating leases
 
$
8,220

 
$
10,272

 
$
8,177

 
$
4,203

 
$
3,826

 
$
32,437

 
$
67,135

Naming rights
 
1,311

 
1,351

 
1,391

 

 

 

 
4,053

Purchase obligations
 
11,421

 

 

 

 

 

 
11,421

Marketing, technology and other services
 
6,781

 
3,008

 
1,683

 

 

 

 
11,472

Total contractual cash obligations
 
$
27,733

 
$
14,631

 
$
11,251

 
$
4,203

 
$
3,826

 
$
32,437

 
$
94,081

 
 
 
Amounts of Commitment Expiration Per Period
Other Commercial Commitments
 
2014
 
2015
 
2016
 
2017
 
2018
 
Thereafter
 
Total
Letters of credit
 
$
1,580

 
$

 
$

 
$

 
$

 
$

 
$
1,580


Operating Leases
 
From time to time we enter into operating leases for facilities and equipment for use in our operations. On March 6, 2014, we entered into amendments to extend the leases on our corporate headquarters and a data center space from their previous expiration of June 30, 2016 to January 31, 2017. The minimum future payments due under these amended operating leases are included in the table above. We have reached agreements in principle to purchase land in Salt Lake City, Utah and develop our future headquarters on the site. Both agreements are non-binding and subject to our due diligence and final negotiation of terms. If we proceed to develop a facility for our new headquarters, we will need to obtain additional financing.
 
Naming Rights
 
During 2011, we entered into a six-year agreement with the Oakland-Alameda County Coliseum Authority (“OACCA”) for the right to name Oakland Alameda County Coliseum (now known as “O.co Coliseum”). Amounts represent annual payments due OACCA for the naming rights. We have the right to terminate this agreement at our sole option, subject to payment of a termination fee.
 
Purchase Obligations