HomeAway Is A Dangerous Destination For Your Investment Capital

The new president looked at me and said: “If I have to be broke at the end of the day, don’t make me be tired as well.” I knew exactly what he meant as I was the Vice President of Operations in a business where much of management’s compensation was based on increasing revenue. The parent company had installed a new President to correct the issues with rapid revenue growth that was not translating into increased profitability.

Our compensation structure for all of the sales related positions was heavily weighted toward increasing sales without regard to the profit margins involved. Everyone worked harder and harder each year and the bonuses got larger and larger, but the profits being delivered to the owners just stagnated. It wasn’t too bad for the executives of that business, it was pretty unpleasant for the owners who had their capital invested in the business.

The whole situation was somewhat reminiscent of many of the mantras I used to hear during the internet stock boom of the late 1990’s when it was all about revenue growth and profit be damned. I have never understood how anything is the operation of a business should be more important than returning value to the owners in terms of profits.

Sadly, there are businesses where rewarding the management team seems to take priority over rewarding the owners, be it a private or publicly traded business. Often, the people who are employed to operate a business in the best interest of shareholders forget the real reason their position exists and begin to run the business in a way that serves their own interest more than that of shareholders.

What Does This Situation Look Like?

As investors, I don’t think any of us object to paying well for top talent to oversee our capital dollars, as long as they produce the kind of returns we expect and increase the value of the business where our investment capital is allocated. However, too often, casual investors confuse share price with value and lose sight of the fact that they are two very different things.

The real value for investors is not in the expansion of revenue or even the gross earnings of a business to which we have allocated our capital, it is an increase in those metrics relative to the portion of the business that we actually own. In other words, even if a business doubles it revenue and net earnings on a year over year basis, the value of my ownership has not changed if the share count has doubled during the same period. If the share price has risen, that would simply mean that new investors would be paying a higher valuation for the business on a price to earnings basis. It is important to always remember that the number of existing shares determines how much of the business I own through the number of shares I hold.

How do the performance metrics of a business look when this type of shareholder dilution is taking place? The information below is taken from the company’s financial reports.

As the table above clearly displays, even though the gross revenue has exploded in this example, it has been completely offset by the growth in the number of shares issued. Therefore, the cash/share being generated for the owners has remained virtually flat over time. You can also see that, in this example, while the business must obviously work harder to generate all of the extra revenue, the net income has actually declined by $2.9 million from 2010 to 2014!

Why would anyone run a business in a way that increased revenue by 266% yet produced less net income? Is that the way to reward investors (owners) most effectively for the allocation of their hard-earned capital? Is this starting to sound a little bit like the business I described in the opening of this analysis? Sadly, it is not the same business, there are many more than just one of these.

Could it be that this is a business being run by people who are far more concerned with their own wallets than they are with the wallets of their employers? Let’s take a quick look and see.

In the business illustrated in the table above, based on the proxy statement include with its 2014 Annual Report the top five executives received combined salaries of $1,965,819.00 in 2014. This equals 14% of the total net profit of the business that belongs to ALL of the owners combined. Does that sound excessive for just five individuals? Think again! In addition to the salaries that were paid to these five executives, they also received performance bonuses equal to a combined $1,223,303.00, equal to an additional 8.7% of the net profits of the business.

In terms of the bonus compensation received by these executives, about 50% is based on increasing revenues. This portion of the bonus is paid without regard to the profit margins involved in those revenues. As the table provided clearly shows, the business is producing far more revenue, in other words working harder, while net profit has seen no benefit from that revenue. The chart below provides an excellent visualization of this revenue growth compared to the net profit of this business.

Does a business where the top five executives are taking salaries and bonuses equal to 22.7% of the remaining net operating profit of the business while failing to increase the actual net profits enjoyed by the owners sound like a good home for your investment capital?

It Appears That A Lot Of Investors Believe It Does

The big difference between this business and the one I described at the opening of this article is that the numbers shown in the table and chart above belong to a company whose shares are traded on a public stock exchange. That business is called HomeAway (AWAY, Financial), and it carries a valuation in the market that is every bit as frightening and it is excessive.

The company, along with its affiliates, operates an online vacation rental property marketplace that enables property owners and managers to market properties for rental to vacation travelers. This is accomplished through vacation rental Websites, such as HomeAway.com, VRBO.com, and VacationRentals.com in the United States; HomeAway.co.uk and OwnersDirect.co.uk in the United Kingdom; HomeAway.de in Germany; Abritel.fr and Homelidays.com in France; HomeAway.es and Toprural.com in Spain; AlugueTemporada.com.br in Brazil; HomeAway.com.au and Stayz.com.au in Australia; and Bookabach.co.nz in New Zealand. It also owns travelmob.com, an Asia Pacific short-term rental site, as well as operates BedandBreakfast.com, a site for finding bed and breakfast properties. In addition, the company offers HomeAway software for professionals at software and Glad to Have You products. As of December 31, 2014, it operates 40 websites produced in 22 different languages. So it does have a wide reach and that is a strong positive.

However, successful investing is not about finding what is popular or finding a business that can quickly grow revenue. Successful investing is about finding fairly or undervalued businesses that can grow profits quickly enough in the future to justify the price we must pay today in order to acquire ownership.

Based on the table below, we can quickly discern that this business is far from cheap based on its current price to the operating results it is producing.

Valuation

Industry Average & Percentile Methodology

When I am evaluating potential investments, I typically like to see a PEG (price to earnings growth ratio) of less than 1 and I will almost never open a position in a stock that carries a PEG of more than 1.5. Therefore, the current PEG for HomeAway at 15 times more than my maximum acceptable level makes this stock just a bit rich for my taste; at least in terms of taking a long position in the stock is concerned.

Based on the most recent 12-month period, it would also take this business 75.81 years to generate enough free cash to return all of their capital to the shareholders even if 100% of the free cash flow were used for that purpose. Considering the emphasis that seems to be placed on expanding revenue versus expanding profit, it is hard to imagine that all of the free cash generated will be used in the best interest of shareholders over management.

What Is A Reasonable Valuation For AWAY?

As has already been clearly demonstrated, this is one VERY expensive business based on any metric of past or present performance regarding profitability. When considering the bullish hype associated with high-flying stocks, my favorite adage is: Remember 1999! The accepted thinking at that time was that revenue growth was king and profits would take care of themselves or they really didn’t matter.

What needs to be determined is what is a reasonable valuation of this business over the next few years. The table below shows the projected forward growth in profitability of HomeAway.

I am very skeptical that this business, or any business, that has only grown earnings per share at a pace of 6.96% annually over the past 5 years during a relatively favorable economic conditions, will suddenly be able to reach an annualized earnings growth rate equal to the 19.59% currently being projected. However, even if that projection is reached, this business is still trading at more than 20 times that valuation.

Considering the $0.14/share that HomeAway earned in 2014, it is difficult to construct any scenario to justify the current share price of $31.17. But, that price represents a discount of 15.5% from the 52-week high of $36.90 that was reached in July of last year.

Final Thoughts And Actionable Conclusions

Valuing a business at 222 times its actual earnings for the previous fiscal year and 445 times its trailing 12-months’ earnings seems insane to me. However, anyone who has studied stock valuations and market behavior as long as I have is well acquainted with some of the insane behavior of market participants when in comes to overvaluing and undervaluing stocks at any given time.

Having said that, at the very least, HomeAway is a stock to avoid at all cost. On the other hand, when we have a stock trading at a ridiculous valuation, coupled with a management team with a very strong incentive to expand sales even it that growth produces no additional profit, one is forced to wonder how long it will be before this high-flyer returns to earth in what would appear to be an inevitable collapse of epic proportions.

Even if the optimistic earnings growth projections are accepted at face value and the stock were to be priced at a very expensive PEG of 3 against its best year of earnings of $0.20/share achieved in 2013, the stock would have to fall to $12/share from its current level to reach that value. This would produce a staggering fall of 61.5% from the current price. This type of overvaluation always entices me to consider short-selling a stock.

But, to consider short-selling a stock, there needs to be a tangible reason for me to predict a price decline within a definable period of time. I believe we have that formula in place with HomeAway. We have a management team that is compensated just as well for increasing sales as they are for increasing profits and it is always easier to expand sales if you are not concerned about profits.

We have a stock that is vastly overvalued today and is already showing signs of weakness in its price even in the fact of a strong overall market. Vastly overvalued stocks tend to crash the hardest when they do finally move lower and once they start down, the momentum can be hard to reverse. HomeAway has moved lower and is still vastly overvalued giving it lots of room to move lower.

Finally, we find ourselves in a market that has gone for an exceptionally long period of time without any significant correction. When general markets correct, the most highly valued stocks get crushed in the process.

Short-selling stocks is not for those of faint heart; but it can be very profitable when executed in a prudent manner and HomeAway presents one of the best opportunities for this technique in the market today.