Homs report Blodget at ML
01:35am EDT 10-May-01 Merrill Lynch (H.Blodget (1) 212 449-0773) HOMS
HOMESTORE.COM:Valuation Impact of Equity-Based Expenses
ML++ML++ML Merrill Lynch Global Securities Research ML++ML++ML
HOMESTORE.COM INC (HOMS/OTC)
Valuation Impact of Equity-Based Expenses
Henry Blodget (1) 212 449-0773
BUY Long Term: BUY
Reason for Report: Company Update
Highlights:
o We have received numerous questions about Homestore's liberal use of
equity to pay for operating expenses, as well as the validity of excluding
these expenses from pro forma EPS. In this note, we analyze this issue in
detail.
o We believe the company's use of equity as an operating currency is valid
(it's a currency, after all). We also believe, however, that investors should
be careful to factor these expenses into valuation calculations. In short,
HOMS is more expensive than it looks.
o As it clearly discloses, Homestore uses equity as a currency to pay for
content, distribution, and marketing services. In total, we estimate that
these stock-based operating expenses add up to about $70mm per year (material,
to say the least).
o Homestore provides GAAP and pro forma EPS. We believe the pro forma
presentation is a good measure of cash consumption/generation. We do not
believe it is a good measure of "operating EPS," however. For this, we include
the equity-based expenses we deem operating.
o When valued on operating EPS, as opposed to pro forma EPS, the stock has a
high multiple. Our 2002E pro forma EPS of $0.95, for example, represents
operating EPS of about $0.44 ($0.29, fully-taxed). At $33, HOMS trades at 75x
this un-taxed operating 2002E EPS (114x, taxed).
o Homestore remains the clear leader in a promising online market, and we
believe the company's prospects remain excellent. Thus, we maintain our Buy (D-
1-1-9) rating.
Price: $32.56
Estimates (Dec) 2000A 2001E 2002E
EPS: NA $0.53 $0.95
P/E: NM 61.4x 34.3x
EPS Change (YoY): NM 79.2%
Consensus EPS: $0.53 $0.91
(First Call: 30-Apr-2001)
Q1 EPS (Mar): -0.14 $0.00
Cash Flow/Share: -0.79 -0.19 $0.42
Price/Cash Flow: NM NM 85.5x
Opinion & Financial Data
Investment Opinion: D-1-1-9
Mkt. Value / Shares Outstanding (mn): $3,614.2 / 111
Book Value/Share (Mar-2000): $12.54
Price/Book Ratio: 2.7x
ROE 2001E Average: NA
LT Liability % of Capital: 0.0%
Est. 5 Year EPS Growth: 62.5%
Next 5 Year Dividend Growth: NA
Stock Data
52-Week Range: $55.00-$16.38
Symbol / Exchange: HOMS / OTC
Options: None
Institutional Ownership-Vickers: 39.9%
Brokers Covering (First Call): 12
For full investment opinion definitions, see footnotes.
Summary
Homestore's fundamental outlook remains very positive, especially over the next
couple of quarters, when revenue from Cendant should begin to kick in. As the
stock approaches our objective, however, we believe investors should be
cognizant of the stock's valuation, especially when the cost of equity-based
operating expenses is factored into forward EPS estimates (the high multiple
means greater volatility and downside if sentiment shifts or something goes
wrong).
Analyzing the Valuation Impact of Equity-Based Expenses. In our opinion,
Homestore's pro forma results provide a good view of the company's cash
consumption/generation, which is a meaningful metric when considering the
company's future cash flows. We do not believe, however, that Homestore's pro
forma results provide a good view of operating earnings. This is because, in
contrast to the pro forma results of other leading Internet companies,
Homestore's pro forma results exclude some non-cash, stock-based expenses that
we regard as operating expenses. We therefore do not view the company's pro
forma or "cash" EPS results as particularly meaningful for valuation
purposes.
The difference between Homestore's pro forma EPS and the pro forma EPS of, say,
Yahoo! or eBay, is that Homestore pays for many of its content, distribution,
and marketing expenses using stock instead of cash (which is a legitimate,
defensible, and even shrewd decision for a young company with a strong
currency, in that it conserves cash). As consideration for its five-year
distribution deal with AOL, for example, Homestore paid AOL $20mm in cash and
3.9mm shares of stock, and it guaranteed that the stock would reach a certain
level within three years ($68.50 per share, making the total value of the deal
approximately $290mm). In contrast, eBay has a four-year distribution and
marketing deal with AOL in which it is paying AOL $75mm in cash (eBay is
expensing the cash in a straight-line basis over the term of the deal). The
equity cost to Homestore of the AOL deal and other deals is included in the
"stock-based charges" line on the income statement. This line is excluded from
pro forma results (under the theory that it is a non-cash expense).
It is important to emphasize that this is not a disclosure issue (Homestore has
clearly disclosed its frequent use of equity as a payment for services). It
is, however, a valuation issue. Because Homestore uses equity as payment for
services that are important to its ongoing operations (content, distribution,
and marketing agreements), and excludes these payments from pro forma results,
the pro forma results are meaningful as a measure of current cash earnings, but
not operating earnings. Yahoo! and eBay's pro forma results, in contrast, are
closer to true operating earnings.
This distinction is important for two reasons. First, it renders comparisons
between the relative P/E multiples on pro forma EPS of HOMS and, say, EBAY,
less relevant (noting that HOMS is trading at a lower P/E than EBAY on pro
forma EPS is irrelevant if eBay's EPS includes expenses that Homestore's
excludes). Second, it raises the possibility that Homestore's cash earnings
power is overstated (if, in the future, Homestore has to pay for its
distribution, marketing, and content deals in cash, its cash earnings margin
might be significantly reduced).
In our estimation, Homestore's stock-based operating expenses totaled about
$19mm in Q1 (vs. pro forma net income of $4mm). In 2001 and 2002, we estimate
that these expenses will total approximately $70mm each year. The expenses are
therefore material to the company's total pro forma net income, which we
project to be $62mm in 2001 and $122mm in 2002. If we recast the income
statement for 2000, 2001, and beyond to account for the use of equity-based
operating expenses, we end up with considerably lower EPS. For example, 2000
EPS drops from ($0.92) to ($1.38), 2001E EPS from $0.53 to ($0.10), and 2002E
EPS from $0.95 to $0.44 (all un-taxed).
Looked at this way, HOMS is trading at 114x fully-taxed 2002E operating EPS of
$0.29, vs. EBAY's current valuation of approximately 60X fully-taxed 2002E EPS
of $0.80. On an apples-to-apples basis, in other words, HOMS is trading at a
considerable premium to the forward P/E multiple of EBAY. We believe investors
should be aware that HOMS's multiple on operating EPS is significantly higher
than it looks on pro forma EPS. We also believe there is upside to our
estimates, however, and we do not believe investors are likely to be overly
sensitive to valuation arguments with regard to this stock.
(HOMS) MLPF&S was a manager of the most recent public offering of securities
of this company within the last three years.
(HOMS) The securities of the company are not listed but trade over-the-counter
in the United States. In the US, retail sales and/or distribution of this
report may be made only in states where these securities are exempt from
registration or have been qualified for sale. MLPF&S or its affiliates usually
make a market in the securities of this company. |
