Shares for Homestore.com, Inc. (Nasdaq: HOMS), operator of Realtor.com, closed down nearly 10 percent Friday following a research report by Merrill Lynch's Henry Blodget, the Wall Street analyst who in 1998 said that Amazon shares would rise to $400 apiece -- and they did.

But Blodget's report was not negative. Indeed, he gave Homestore a "buy" rating and said the company "remains the clear leader in a promising online market, and we believe the company's prospects remain excellent." At the same time he told investors that "HOMS is more expensive than it looks."

Public companies today routinely describe their financial picture in terms of "pro forma" results and also under "generally accepted accounting principles" or GAAP. Companies can define pro forma results by determining what to include or exclude in the calculations, while GAAP figures must adhere to less-flexible accounting rules.

In its last quarterly report, as an example, Homestore announced pro forma revenues of $118.4 million, as well as a pro forma profit of $4 million. In contrast, on the basis of generally accepted accounting principles (GAAP), Homestore said it had revenues of $105.5 million for the first quarter and a net loss of $67.1 million.

Blodget's report concerns the manner in which Homestore allocates pro forma expenses and how such costs are shown in public statements. If you count certain non-cash stock-based expenses in pro forma results, says Blodget, then by his estimate in 2000 Homestore would have had additional pro forma costs of $46.761 million. For this year, Blodget says non-cash stock-based charges will amount to $73.116 million.

The issue is not one of disclosure -- Blodget says Homestore "has clearly disclosed its frequent use of equity as a payment for services." Nor does Blodget disagree with reported GAAP numbers. Instead, the question is how best to show company pro forma expenses and thus pro forma profits, losses and earnings per share.

Rather than paying cash for certain services, Homestore grants stock -- and then in some cases guarantees the market value of that stock at certain points in the future. Stock represents equity in the company and is considered a "non cash, stock-based" charge that is not included as a cost when the company reports pro forma earnings. But, says Blodget, such costs should be regarded as "operating expenses" -- charges that would increase company pro forma costs and thus lower company pro forma profits or increase pro forma losses.

Blodget says Homestore's use of stock is a "legitimate, defensible, and even shrewd decision for a young company with a strong currency, in that it conserves cash." But, he explains, when the company reports pro forma results to investors, they "exclude some non-cash, stock-based expenses that we regard as operating expenses."

As an example Blodget says Homestore has a five-year distribution arrangement with AOL under which it paid $20 million in cash and gave AOL 3.9 million shares. Those shares are guaranteed to reach $68.50 under certain circumstances, thus Blodget says the full cost to Homestore is approximately $290 million. That $290 million, says Blodget, should be seen as a pro forma cost paid out over the five-year term rather than as a non-cash item. He says the cost of the AOL deal should be shown as a quarterly pro forma expense of $13 million.

"Because we view the costs of the content, distribution, and marketing deals as operating expenses, however, we believe they should be considered when gauging the earnings power of the company," he said.

Blodget says that eBay has a four-year deal with AOL for which it paid $75 million. This $75 million is treated as an expense that is being paid out over the four-year term of its AOL agreement.

As well, Blodget says, considering stock as a non-cash expense "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)."(Parenthesis his.)

In addition to the AOL deal, Blodget also discusses Homestore's Broker Gold/MLS plans.

Blodget says Homestore has content deals with 770 of the nation's 800 largest MLS systems, 60 of the 200 largest brokerages, the six largest franchises, and nine of the 10 largest homebuilders.

"The company," says Blodget, "has issued warrants to brokers and MLSs to provide their listings to Homestore for periods usually ranging from 12 to 30 months. Typically, these warrants have been fully vested, non-forfeitable, and immediately exercisable upon issuance."

Blodget says that the cost of such warrants was $3 million in the March quarter, but that such expenses are likely to decline.

"Arguably," says Blodget, "the company won't have to offer warrants to induce brokers and MLSs to share their listings in the future, assuming that Homestore's traffic continues to ramp and it becomes a distribution channel brokers and MLSs can't afford to pass up. Eventually, in fact, the brokers may even pay Homestore for distributing their listings -- we remember the days when AOL reached critical mass and went from paying content providers for content to receiving payment for distribution. However, we believe that at this point this is too generous an assumption (one that, in any case, won't likely affect the next year or two)." (Parenthesis his.)

On Friday, Homestore stock closed at $29.91, down $2.97 (9.03 percent) from Thursday. However, the stock traded as low as $26.55 during the day and then recovered. In the past year, prices for the company's stock have ranged from $16.37 to $55.

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