(EDGAR Online via COMTEX) -- ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion and analysis contains forward-looking statements relating to future events or our future financial or operating performance that involve risks and uncertainties, as set forth above under "Special Cautionary Note Regarding Forward-Looking Statements." Our actual results could differ materially from those anticipated in these forward-looking statements as a result of certain factors described in this Annual Report on Form 10-K, including those set forth above under "Special Cautionary Note Regarding Forward-Looking Statements" or in Item 1A under the heading "Risk Factors" or elsewhere in this Annual Report on Form 10-K. In addition, our future results may be significantly different from our historical results.
The following discussion and analysis also should be read in conjunction with the disclosures in Item 1. "Business" under "Our Retail Business" and "Our Medici Business," as well as the risk factors described in Item 1A. "Risk Factors." Our ability to pursue some or all of the strategies described below, and the extent to which we would be able to pursue some or all of them, will depend on the resources we have available, and may require significantly more capital than we currently have. These costs have been and are expected to continue to be material. See "Management's Discussion and Analysis of Financial Condition and Results of Operations-Liquidity and Capital Resources" below.
Our Retail Business
Our online Retail business seeks to provide goods to furnish and accessorize "Dream Homes for All" of our target customers-consumers who seek smart value on quality, stylish merchandise at competitive prices. In our Retail business, customer demand increased significantly beginning in the second half of March 2020 and continuing through December 2020 as consumers migrated to online shopping as a result of the COVID-19 pandemic. We regularly update our home furnishings product assortment to meet the evolving preferences of our customers and current trends. Our products include, among others, furniture, home decor including rugs, bedding and bath, home improvement, and kitchen and dining items. Our supply chain allows us to ship directly to our customers from our suppliers or from our warehouses. See Item 1-"Business-Our Retail Business" for further information on our Retail business.
Strategies for our Retail Business
Our Retail business initiatives enable our long-term focus on our three brand pillars, "Product Findability," "Smart Value," and "Easy Delivery and Support." Initiatives for the Retail business include:
Improve Mobile Experience - As more website visitors move to mobile, we are focusing on ensuring our mobile experience is fast, frictionless, and meets the unique needs of the mobile shopping journey. We believe an improved mobile experience improves product findability, conversion, search engine rankings, and organic traffic.
Overhaul Discounting and Pricing Experience - "Smart Value" is the central brand pillar of our value proposition. We believe clarifying our pricing and discounting experience allows customers to more confidently purchase at Overstock. Savvy shoppers expect a "smart deal," including saving through coupons, site sales, Club O rewards and financing. We have historically offered free shipping on orders over $45. We initially introduced free shipping on everything to the continental U.S in late March 2020 in response to the COVID-19 pandemic stay-at-home orders, with the goal of easing consumers' financial burdens. As this shopping benefit continued to resonate with new and existing customers, we made the limited-time offer permanent for shoppers across the continental U.S. We believe our net promoter score (NPS), repeat purchase rates and conversion will improve as we better optimize the mix of offers and clarify the pricing and discounting experience.
Real Time Performance and SKU Profitability - We are improving our ability to address site, assortment and pricing issues more quickly by enhancing our real-time visibility into site, category, and marketing channel performance. We believe this initiative allows us to improve margin by more quickly resolving site issues for an improved customer experience.
Expand Partner Sponsored Marketing - We are expanding the "Overstock Sponsored Product" program, a platform for our drop ship partners to promote their products to shoppers through a cost-per-click auction platform. In addition, we have implemented a marketing allowance program required across our partner network. This marketing allowance program allows us to optimize the marketing promotion type, mix of acquisition spend and on-sale assortment to better meet the needs of our target customer segments and adapt to seasonal relevance.
Our Medici Ventures Business
Our Medici business initiatives include our wholly-owned subsidiary, Medici Ventures, which conducts the majority of its business through its majority-owned subsidiary tZERO. Medici Ventures also owns strategic minority equity interests in several blockchain-related companies, all of which are startup businesses, businesses in the development stage, or businesses with a short operating history. As a result of the transaction described in Item 1-"Business-Our Medici Business-Pelion Transaction Agreement" and Item 8 of Part II, "Financial Statements and Supplementary Data"-Note 27-Subsequent Events, Medici Ventures has discontinued providing the services of its software engineers, developers, or other technologists to other blockchain companies. Active seats on the boards these companies previously held by Medici Ventures will be filled by nominees of Pelion following the close of the Pelion Transaction Agreement.
Our tZERO Business
tZERO is a leader in blockchain innovation and liquidity for digital assets. tZERO and its affiliates are working with regulators and other stakeholders to expand the role of blockchain in the lifecycle of digital securities and to facilitate the infrastructure, issuance, recording, trading, clearing, settlement, and regulatory compliance of "digital asset securities" described in the July 8, 2019 Joint Staff Statement on Broker-Dealer Custody of Digital Asset Securities and the Custody of Digital Asset Securities by Special Purpose Broker-Dealers, Exchange Act Release No. 90788 (Dec. 23, 2021) in a manner consistent with existing market and legal infrastructure. In addition, tZERO also maintains certain businesses not focused on digital securities, including the broker-dealer activities of certain of its subsidiaries. See Item 1-"Business-Our Medici Business-tZERO" for further information on our tZERO business.
The transaction described in Item 1-"Business-Our Medici Business-Pelion Transaction Agreement" and Item 8 of Part II, "Financial Statements and Supplementary Data"-Note 27-Subsequent Events is not expected to have a significant impact on tZERO's business strategies.
Strategies for our tZERO Business
tZERO's primary initiatives currently consist of the following:
Promote trading - tZERO ATS, LLC is focused on onboarding and trading high-quality digital securities. tZERO ATS, LLC is working with prospective issuers spanning various industries, including real estate, technology, health care and sports, as they seek to issue new digital securities using the tZERO Technology Stack and provide liquidity to existing investors. Additionally, tZERO is enhancing the tZERO Technology Stack to support third party issuance protocols in order to support securities which have been digitally enabled by other technology companies and has established relationships with market participants to help prospective issuers raise capital, prior to tokenizing and trading on the tZERO ATS.
Enhance liquidity - tZERO ATS, LLC is focused on enhancing liquidity. To achieve this, tZERO ATS, LLC is in continual discussions with additional broker-dealers interested in subscribing to the tZERO ATS, which would enable their customers to trade digital securities traded on the tZERO ATS. tZERO also continues to develop new avenues for investors to access digital securities including tZERO Markets, an SEC-registered broker-dealer able to accept retail customers and BSTX, which may seek regulatory approval for a U.S. national exchange facility and thereby provide a new trading venue for digital securities.
Create a world class trading experience - tZERO continues to seek opportunities to enhance the tZERO Technology Stack and improve investors' trading experience for all types of financial products. tZERO is working to allow digital securities to be traded via a mobile application to complement their accessibility via tZERO Markets' web platform. It is also developing further enhancements of tZERO Crypto's separate wallet and exchange services, such as providing additional features for its mobile application and ensuring it is accessible on a web platform. tZERO has and will partner with third-parties in order to provide this functionality in the most efficient and effective manner. tZERO believes a world-class combined trading experience will be key to investors' adoption of digital securities and tZERO's other products and services, including cryptocurrencies.
Advocacy - tZERO operates businesses which are subject to complex and often uncertain legal environments and believes active engagement with regulatory authorities is necessary to realize the full potential of its business. tZERO continues, in partnership with other industry participants, to advocate regulatory reform with legislators and regulators in order to spur market innovation through the adoption of distributed ledger technology and digital asset securities.
tZERO also continues to identify, evaluate and pursue various opportunities for strategic transactions to enhance the services and expertise it offers its customers as well as to refine its strategic operational focus. Subject to board approval, tZERO's management exercises substantial discretion in identifying appropriate strategic transactions and negotiating the terms of such transactions. Management's determinations are based on numerous financial, strategic and operational assumptions, and there can be no assurance that such assumptions will prove to be true. Moreover, such strategic transactions may fail to produce the benefits expected at the time tZERO enters into such transactions.
Critical Accounting Policies and Estimates
The preparation of financial statements in conformity with U.S. generally accepted accounting principles ("GAAP") requires estimates and assumptions that affect the reported amounts of assets and liabilities, revenues and expenses, and related disclosures of contingent assets and liabilities in the consolidated financial statements and accompanying notes. The SEC has defined a company's critical accounting policies as the ones that are most important to the portrayal of the company's financial condition and results of operations, and which require the company to make its most difficult and subjective judgments, often as a result of the need to make estimates of matters that are inherently uncertain. Based on this definition, we have identified the critical accounting policies, estimates and judgments addressed below. We also have other key accounting policies, which involve the use of estimates, judgments, and assumptions that are significant to understanding our results. For additional information, see Item 8 of Part II, "Financial Statements and Supplementary Data"-Note 2-Accounting Policies and Supplemental Disclosures. Although we believe that our estimates, assumptions, and judgments are reasonable, they are based upon information presently available. Actual results may differ significantly from these estimates. Our critical accounting policies are as follows:
revenue recognition; and
We derive our revenue primarily from our Retail business through our Website from merchandise sold at a point in time and shipped to customers. When we are the principal in a transaction and control the specific good or service before it is transferred to the customer, revenue is recorded gross; otherwise, revenue is recorded on a net basis.
Revenue is recognized when control of the product passes to the customer, typically at the date of delivery of the merchandise to the customer or the date a service is provided and is recognized in an amount that reflects the expected consideration to be received in exchange for such goods or services. As such, customer orders are recorded as unearned revenue prior to delivery of products or services ordered.
As we ship high volumes of packages through multiple carriers, 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 based on historical data. 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 income before taxes for the year ended December 31, 2020 (in thousands):
Year Ended December 31, 2020 Increase Increase (Decrease) (Decrease) Income Before Change in the Estimate of Average Transit Times (Days) Revenue Income Taxes 2 $ (8,934) $ (1,638) 1 $ (3,567) $ (627) As reported As reported As reported (1) $ 11,266 $ 2,297 (2) $ 20,481 $ 4,149
Shipping and handling is considered a fulfillment activity, as it takes place prior to the customer obtaining control of the merchandise, and fees charged to customers are included in net revenue upon completion of our performance obligation. We present revenue net of sales tax, discounts, and expected refunds.
Our merchandise sales contracts include terms that could cause variability in the transaction price for items such as discounts, credits, or sales returns.
We recognize gift cards and Club O rewards in the period they are redeemed. Unredeemed gift cards and Club O rewards not subject to requirements to remit balances to governmental agencies are recognized as net revenue based on historical redemption patterns.
Our Other revenue occurs primarily through our broker-dealer subsidiaries in our tZERO segment. We recognize revenue for our broker-dealer subsidiaries based on the gross amount of consideration that we expect to receive on securities transactions (commission revenue) on a trade date basis.
Accounting for the tZERO Digital Security offering
On December 18, 2017, tZERO launched an offering (the "TZROP offering") of the right to acquire tZERO's Preferred Equity Tokens, Series A ("TZROP") through a Simple Agreement for Future Equity ("SAFE"). The TZROP offering closed on August 6, 2018, and on October 12, 2018 tZERO issued the TZROP in settlement of the SAFEs. The SAFEs were accounted for as a prepaid contract to obtain equity interest in tZERO and were classified as a component of noncontrolling interest in our consolidated financial statements. The TZROP issued under the TZROP offering to settle the SAFEs represent a form of preferred stock and are classified as a component of noncontrolling interest within our consolidated financial statements. For additional information, see Item 8 of Part II, "Financial Statements and Supplementary Data"-Note 16-Stockholders' Equity.
For information about recent accounting pronouncements, see Item 8 of Part II, "Financial Statements and Supplementary Data"-Note 2-Accounting Policies and Supplemental Disclosures.
Comparison of Years Ended December 31, 2020 and 2019
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 "Special Cautionary Note Regarding Forward-Looking Statements."
Revenue increased 75% in 2020 compared to 2019. This increase was primarily due to increased Retail product sales resulting from a 71% increase in customer orders, 111% new customer growth, and strong repeat customer behavior, due in part to a consumer migration toward online shopping in response to COVID-19 stay at home mandates.
Gross profit increased 98% in 2020 compared to 2019 primarily due to an increase in Retail product sales and an increase in gross margin. Gross margin increased to 22.7% in 2020, compared to 20.1% in 2019, primarily due to our new partner marketing allowance program that was fully rolled out in the second quarter of 2020, which requires all of our partners to participate and allows us to advertise more strategically to our customers. Gross margin also benefited from reduced promotional discounting as we balanced spend to support new customer acquisition efforts, gained leverage in our fixed warehouse infrastructure, increased fees charged to partners due to unmet contractual service levels, and lower customer service costs as sales outpaced staffing expense during the early part of the COVID-19 pandemic.
Sales and marketing expenses as a percentage of revenue increased to 10.3% in 2020 compared to 9.8% in 2019 primarily due to increased spending to support our customer acquisition strategy, resulting in a 111% increase in new customers compared to the twelve months ended December 31, 2019.
Technology expenses increased $1.7 million in 2020 compared to 2019 primarily due to staff-related costs, including accrued bonuses.
General and administrative expenses decreased $10.9 million in 2020 compared to 2019 primarily due to an $8.6 million reversal of a legal settlement accrual, a $2.5 million Visa settlement, a $4.3 million decrease in consulting expenses, and a reduction in discretionary spending due to adjustments related to the COVID-19 pandemic, partially offset by an $8.8 million increase in staff-related costs, including accrued bonus.
Our consolidated cash and cash equivalents balance increased from $112.3 million as of December 31, 2019 to $516.5 million as of December 31, 2020, an increase of $404.2 million, primarily as the result of cash inflows from operating activities of $196.5 million and from the sale of common stock of $195.5 million, net of offering costs (including commissions) for the year ended December 31, 2020 and $47.5 million of proceeds from cash generated by new debt agreements, which was partially offset by expenditures for fixed assets of $19.1 million during the year ended December 31, 2020.
Additional commentary related to Medici Ventures
The majority of Medici Ventures' business is its 80% interest in tZERO, which is described below. As described in Item 1-"Business-Our Medici Business-Pelion Transaction Agreement" and Item 8 of Part II, "Financial Statements and Supplementary Data"-Note 27-Subsequent Events, we entered into a transaction agreement with Pelion that, when consummated, will alter our ownership of Medici Ventures. The remaining business activities of Medici Ventures are focused on developing and advancing blockchain technology. As a result of its business model of providing technical assistance to companies in which Medici Ventures owns an interest, as well as the early stage of development of the companies in which it owns interests, Medici Ventures has not yet generated material revenues. For the year ended December 31, 2020, our pre-tax loss in our Medici Ventures business, excluding our loss in our tZERO business, was $10.0 million, and we expect to continue to incur significant losses in our Medici Ventures business during 2021.
Additional commentary related to tZERO
To date, tZERO has focused primarily on developing its businesses and exploring opportunities for novel financial applications of blockchain technology. tZERO does not yet have a stable customer base or backlog orders and has not yet generated any meaningful revenue from any commercially available applications of its blockchain initiatives. The businesses, products, and services that tZERO is pursuing or contemplating will require substantial additional funding, initially for technology development and regulatory compliance, as well as for working capital, marketing and sales, and other substantial costs of developing new products and businesses in emerging areas of technology. For the year ended December 31, 2020, our pre-tax loss in our tZERO business, excluding our loss in the non-tZERO portion of our Medici business, was $45.7 million, and we expect to continue to incur significant losses in our tZERO business during 2021. As described in Item 1-"Business-Our Medici Business-Pelion Transaction Agreement" and Item 8 of Part II, "Financial Statements and Supplementary Data"-Note 27-Subsequent Events, we entered into a transaction agreement with Pelion that, when consummated, will alter our ownership of tZERO.
Additional commentary related to COVID-19
Overstock has continued to respond to the challenges and opportunities created by the COVID-19 pandemic. In our Retail business, customer demand increased significantly beginning in the second half of March 2020 and continuing through December 2020, particularly in our key home furnishings categories. We have seen a substantial year over year increase in our website traffic and number of new customers. Our online-only platform and partner network with thousands of fulfillment centers have enabled us to meet this increase in demand. Our three warehouses have remained operational based on our sustained implementation of sound safety measures, including staggered shifts and social distancing. We have hired in key areas throughout the company to support our current and expected growth. There are continued challenges created by the increased volume throughout the supply chain in factory production capacity, inbound freight delays, as well as carrier delivery constraints and fulfillment performance from some suppliers. Most of our Medici Ventures blockchain companies have seen relatively little disruption, and several are working on solutions to problems exacerbated by the global pandemic. We have evaluated and implemented a phased re-entry plan for our offices; most of our corporate employees continue to work from home without incident. We cannot predict how the COVID-19 pandemic or the ongoing development and rollout of vaccinations will unfold in the coming months. Nevertheless, the challenges arising from the pandemic have not adversely affected our liquidity, revenues, or capacity to service our debt, nor have these conditions required us to reduce our capital expenditures.
Results of Operations
Our Annual Report on Form 10-K for the year ended December 31, 2019, filed March 13, 2020, includes a discussion and analysis of our year-over-year changes, financial condition, and results of operations for the years ended December 31, 2019 and 2018 in Item 7 of Part II, "Management's Discussion and Analysis of Financial Condition and Results of Operations."
Retail revenue, costs of goods sold, gross profit and gross margin
The following table reflects our Retail net revenue, costs of goods sold, gross profit and gross margin for the years ended December 31, 2020 and 2019 (in thousands):
Year ended December 31, Retail 2020 2019 Revenue, net $ 2,493,915 $ 1,434,974 Cost of goods sold Product costs and other cost of goods sold 1,823,755 1,081,051 Fulfillment and related costs 98,804 65,974 Total cost of goods sold 1,922,559 1,147,025 Gross profit $ 571,356 $ 287,949 Year-over-year percentage growth Revenue, net 73.8 % Cost of goods sold Product costs and other cost of goods sold 68.7 % Fulfillment and related costs 49.8 % Total cost of goods sold 67.6 % Gross profit 98.4 % Percent of total revenue, net Cost of goods sold Product costs and other cost of goods sold 73.1 % 75.3 % Fulfillment and related costs 4.0 % 4.6 % Total cost of goods sold 77.1 % 79.9 % Gross profit 22.9 % 20.1 %
The 74% increase in Retail net revenue for the year ended December 31, 2020, as compared to the same period in 2019, was primarily due to increased Retail product sales resulting from a 71% increase in customer orders, 111% new customer growth, and strong repeat customer behavior, largely due to a consumer migration toward online shopping in response to COVID-19.
International sales were less than 2% of total net revenues for 2020 and 2019.
Our overall gross margins fluctuate based on changes in supplier cost and/or sales price, including competitive pricing; inventory management decisions; sales coupons and promotions; product mix of sales; and operational and fulfillment costs. Fulfillment costs include all warehousing costs, including fixed overhead and variable handling costs (excluding packaging costs), as well as merchant processing fees associated with customer payments made by credit cards and other payment methods and other variable 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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Feb 26, 2021
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