Slow-Playing LoopNet For Now

On December 28 I initiated a sell recommendation for shares of Loopnet (LOOP) and wanted to explain in more detail why I decided to sell our 1/4 position at this time after only recently recommending the company.

First of all, before I go into the reasons why I didn’t like the business at this time, I want to quickly go over the initial reasons why I was attracted to Loopnet in the first place.

Before I do that, here’s a brief rundown of what Loopnet does:

Loopnet’s online marketplace, available at www.LoopNet.com, enables commercial real estate agents, working on behalf of property owners and landlords, to list properties for sale or for lease and submit detailed information on property listings, including qualitative descriptions, financial and tenant information, photographs and principal property characteristics to find a buyer or tenant.

Commercial real estate agents, buyers and tenants use the LoopNet online marketplace to search for available property listings that meet their commercial real estate criteria.

In addition to its primary LoopNet offering, the company also operates BizBuySell, an online marketplace for operating businesses for sale.

Loopnet also generates revenues by selling its LoopLink online real estate marketing and database services suite to commercial real estate firms and by selling advertising and sponsorships on the company’s website to anyone who is seeking to market products or services to the LoopNet registered member base.

In addition, through its RecentSales product, members can access historical sale transaction information on a monthly subscription or per property record basis.

Here’s why I initially liked and still like the company:

• Market leader in their field (largest online commercial real estate website)
• Huge increasing margins (Gross (89%), Operating (47%), and Net (30%))
• Huge cashflows (more of their profit drops to the bottom line)
• Huge stash of cash ($100 million, about $2.60 per share)
• Nice, albeit slowing sales growth (projected to be about 30% for fiscal 2008, down from 40% in 2007)
• Nice, albeit slowing profit growth (projected to be about 30% for fiscal 2008, down from 45% in 2007)
• Scaleable business, with a critical mass of users
• Trading at or near a 52-week low
• Large opportunities for growth overseas, and in the US
• Buy-out target for a larger player, such as Ebay, Microsoft, Google, etc.

As you can see, there is a lot to like about the Loopnet business. It’s all online, there is low overhead, and they constantly make huge wads of cash that they sock away every single quarter for a rainy day.

So, you might be asking, what in the world would contradict the amazing numbers that I relayed above?

Not So Fast…

When analyzing the Loopnet story, one must start with the key business metrics that Loopnet uses to gauge their progress and growth.

These can be broken down into 5 key metrics:

• Total Registered Members: This includes premium and basic members.
• Total Number of Premium Members: This is the total number of paying members on the Loopnet.com website
• Conversion Rate of Registered to Premium Members: This is the rate at which total members convert to Premium members.
• Average Monthly Subscription Price: The average price paid per month by all Premium subscribers
• Cancellation Rate of Premium Members: The average rate that Premium members cancel their subscriptions.
• In addition, Loopnet takes into account the total number of listings on their website, and total property profiles viewed (not included).

5 Key Business Metrics:

It doesn’t take long to filter out what is happening with Loopnet and the good news and bad.

First the good news: Total registered members and total number of listings are still growing rapidly.

Since the website is free to anyone that wants to sign up, this metric is not quite as important as the others that follow, although the more users that are on a website, the more chance you have of converting that user to a paid subscriber over time.

The bad news: Every other metric, except average monthly subscription price, is slowing or declining, or increasing in a bad way (ie: Cancellation Rate).

Some of this can be attributed to the laws of large numbers, and the fact that it gets harder and harder to grow certain metrics as your business improves and you have already reached a certain size.

Looking at the premium members, where Loopnet actually makes over 80% of its money, the total number of paid subscribers looks to be slowing in terms of % growth but only moderating slightly when taken into context of the pure numbers. For instance, about 21,000 new premium members were added between 2005 and 2006, while 16,000 were added between 2006 and 2007. While the growth is slowing, down to about 20%, the actual total number of subscribers is not slowing as dramatically in absolute terms.

As a corollary to this, the conversion rate of free members to paid subscribers is also decreasing, but again, as you grow your base of free members larger and larger, its obvious that the conversion rate will slow and decline as you get more and more people that are merely interested in looking around, listing properties for free, or seeing “what’s out there”.

In fact Loopnet stated as much in their latest 10-Q filings stating:

We believe that a decline in the third quarter of 2007 in our premium to basic member conversion rate to approximately 3.7% is attributable to an increasing proportion of principals (i.e., investors and tenants) in our membership base, who convert to premium membership at a lower rate than the professional agents and brokers in the market, and an approximately 17% increase in the average subscription prices which we charge our premium members.

Loopnet goes on to explain why they think this has taken place:

During the current quarter the commercial real estate credit markets experienced some degree of tightening as a result of the subprime issues affecting the residential real estate credit markets. We believe that an increase in our average monthly cancellation rate in the third quarter of 2007 to slightly above 5% is attributable to the credit tightening that the commercial real estate industry experienced and the increase in the average subscription prices which we charge our premium members.

Still, the numbers are what they are, and it’s obvious that Loopnet is slowing down, for a potential variety of reasons.

The in-between news: While average subscription price has increased, leading to more revenue and profit, this is also a probable contributor to Loopnet’s slowing premium membership base and their accelerating churn rate, as indicated above.

According to the company, they will continue to raise their premium membership rate (which is still a bargain if you really think about it), while at the same time anticipating increased churn/cancellations for premium members and lower conversion rates.

The bottom line: Loopnet’s growth metrics are slowing while they continue to increase prices, experience shrinking conversions, and a higher churn rate!

Needless to say, these metrics bear watching closely. They tell an interesting story of a company that is becoming more and more popular but has potentially run into a snag, whether because their pricing has become too high, or their size has begun to moderate or outside forces like the current credit market problems have had a more robust effect on their business.

Either way, there’s a very good reason, real or perceived, as to why Loopnet’s shares have sold off in the last couple of months and the short interest in the stock has skyrocketed.

In light of only these pieces of data, I would be more comfortable with a better risk/reward proposition going forward on the company’s shares

But Wait, There’s More…

If the above metrics didn’t scare you, or at least give you pause, then I have further evidence that while Loopnet is a great company that provides an excellent niche service with high margins, and a critical mass to buyers and sellers, there is enough evidence that right now, we should be waiting for a better entry point. Among the added reasons are the following:

• Credit crunch/real estate collapse:

You know this has had an adverse effect on Loopnet if they mention it in their filings.

Worse yet, the commercial real estate market was supposed to be less susceptible to this crisis as sales are usually performed between more financially solid investors/buyers with better credit than a strapped homeowner.

Finally, its evident from the metrics above that Loopnet’s business was slowing BEFORE this stuff started happening on a large scale and BEFORE it trickled down to their business. How much more is there left? How much longer will this impact their business? When will it stabilize, slow down or reverse?

• Relying on 2 states, the hardest hit, for nearly 40% of their revenue!

Loopnet currently has 40% of their premium membership base in California (28%) and Florida (12%).

These were some of the hardest hit states in the country, and Loopnet relies on them for the bulk of their paying subscriber base.

• Seasonality/Cyclicality:

From Loopnet’s latest 10-Q filing:

We have experienced seasonality in our business in the past, and expect to continue to experience it in the future. While individual geographic markets vary, commercial real estate transaction activity is fairly consistent throughout the year, with the exception of a slow-down during the end-of-year holiday period. The impact that this has had on our business is that the growth rate in the fourth quarter of each year, while positive, has been slower than in the first three quarters of each year. We expect this pattern to continue.

So this begs the question: If they already experience a slow down each year right around this time, then what are we going to get this year with the added pressures outlined above?

• Slowing sales/profit growth:

While I discussed this briefly above, it bears repeating. Loopnet is a high growth stock, with a high growth multiple.

These kinds of stocks get hammered when their growth rates finally slow down, or encounter a blip for short periods of time.

While the stock has declined from an all-time high earlier in the summer, I believe that current valuation doesn’t give us enough of a cushion should their sales and profit growth slow further.

In addition, if Loopnet encounters a seasonal drop, or a larger drop via the added pressures from external forces (not to mention some of which are Loopnet’s own doing, such as continuing to increase prices to premium members), we could see a much larger slowdown in growth than even the most pessimistic views, thus further causing weakness to Loopnet’s.

• Insider selling that just doesn’t quit:

I don’t know about you, but this freaks me out. Insider buying is great, insider selling is usually ok too, but what’s going on at Loopnet is ridiculous.

There is constant selling by all the insiders: CEO, CFO, CMO, Directors, etc., all across the board ALL YEAR long. They have sold lots anywhere from 5,000 - 20,000 shares every single week for the last year and ever since the lock-up period expired.

Like I said, insider selling is a normal part of doing business. Company executives deserve to cash out some of their chips for all the years of hard work they put into a company, but this unrelenting selling is far beyond anything that I’ve ever seen before.

One caveat: I have been trying to reach someone at investor relations to speak with them about this to find out what’s going on. If they can give me a reasonable explanation, other than the usual “it’s a part of their diversification strategy”, it might change my mind. For instance if there are predetermined trust sales (which there have been) and perfectly reasonable explanations for the selling, that would change things.

Also, insiders still own over 30% of the company, so it’s not like they have diminished their stake significantly enough to warrant a full-blown panic, but this level of selling, even into the recent 52-week lows, is alarming.

• Valuation metrics, DCF not looking so great, P/E, P/S, etc:

Let’s face it, Loopnet is an expensive stock. Less so now than it was a few months back, but with slowing growth and growing concern about its business in the near future, a shrinking multiple on all valuation metrics is justified, and in fact needed to cushion the risk/reward proposition.

Using various metrics, such as discounted cash flow [DCF], P/E ratios, P/S, etc., Loopnet is still overvalued even at today’s depressed levels, not inclusive of slowing business trends and shrinking sales growth.

In fact when plugging in the numbers for the DCF, which is the king of all valuation metrics, I get a fair value anywhere from $13-18 per share. LOOP stood at about $14 today.

In other words, there is little upside potential, and a lot of downside risk. Not the warmest of scenarios.

Further, if you look at more traditional measures such as the P/E ratio, LOOP stands at a forward P/E of about 23, with growth projected by analysts of about 27.5%, which yields a PEG of about .83, which is reasonable and even “cheap”. BUT I will bring to your attention that only a few months ago, this estimate was 35%, which indicates analysts have been lowering their future growth estimates for Loopnet’s earnings.

Knowing that analysts are notorious for OVER-estimating to the upside, this is yet another reason to be cautious. In fact for 2008, analysts predict earnings to rise only 24%! Granted, LOOP has beaten earnings every single quarter as a public company, so this could be conservative at best, but it goes to show that even analysts are being cautious in their future estimates only 1 year out.

• Fierce competition:

Loopnet is under siege on all sides. They face competition from CoStar Group (Nasdaq: CSGP), Property Line, newspapers, The National Association of Realtors and the potential big boys like Ebay, Craigslist, Google, etc., that could decide to set up shop in Loopnet’s neighborhood any time they want.

This hasn’t been as large a problem before as Loopnet was scaling its business, but it could be now that things are slowing down and comps are getting harder to come by.

In addition, because Loopnet’s business model is scalable, and offers low barriers to entry, anyone could decide to do what Loopnet is doing and just charge less, thus creating competition, and hurting the business going forward.

• Increased short interest, downward pressure on the stock:

Short interest in the stock has risen dramatically lately.

As of November 27th, about 7.35 million shares of Loopnet were held short. This represents about 20% of the total float.

This is an extremely high number, and increased from 5.25 million shares short the prior month.

This could be a one of the reasons why the shares have sold off lately and initially presented us with a great buying opportunity.

Of course, there is a reason why the shares are short: It’s because someone thinks they are overvalued and that there are problems.

Short interest isn’t necessarily a harbinger of things to come, but it does raise some red flags.

I feel that the short interest is a result of the sub-prime mortgage mess, and the expectation of short sellers that Loopnet will suffer with slowing subscriber growth and revenue shortfalls in their coming earnings periods as the problems in the residential real estate market trickle their way into the commercial real estate market, which up till now was mostly immune, and seeing steady growth and transaction volume.

The Bottom Line

Simple right?

Not really…it’s all shades of grey. I struggled with the Loopnet investing thesis for a week or so now, as I steadily uncovered more and more problems that contradicted my initial investment thesis to the point of which I began to actually doubt that investment thesis, and ultimately, reverse it for the time being.

The whole goal of investing, in fact rule #1 according to Warren Buffett, is to preserve capital.

When analyzing various stocks for investment, the total context of the situation must be taken into account.

Merely buying shares because they are “cheap” is a losing mentality when the underlying fundamentals of the company are not fully understood.

I believe that Loopnet represents a wonderful investment opportunity…just not at today’s price.

While it may appear that shares are severely undervalued (and they are in a historical context), it’s also true that things are different now than they have been in the past.

Therefore, a careful reevaluation of the Loopnet business model needs to be looked at, and new rationale taken into account.

I want to see how this quarter plays out earnings-wise, and slow play the Loopnet story until I feel that I will be compensated for the risk that I will be taking on for owning shares in the company.

Disclosure: None

Comments

[Dignan:]

Chris: You need to take a closer look at LOOP and the fundamentals of the business. As a commercial real estate professional, I can't imagine having to rely on a service like LoopNet. None of their data is verified nor do they even employ researchers. Many of the properties that I have viewed on their site are duplicates.

On top of the fact that they don't have anywhere close to the largest database of commercial properties - not even close.

And their online traffic is dying - check out this link: www.alexa.com/data/det...

LOOP will be toast within the next few years. Mark my words.

2008 Jan 07 10:17 PM

[Ogradius:]

Chris: I see Fidelity has a large position in LOOP. Are they buying more at the current price ($12.42)?

2008 Jan 07 11:34 PM

[User 137360:]

I don't know about Loopnet being toast, but why pay to advertise businesses and commercial real estate for sale? Check out GlobalBX.com

2008 Jan 08 11:07 AM

[globalview99:]

I'm sure someone once said that ebay would be toast in a couple years.

The fact of the matter is that commercial real estate is different than residential RE in that the comm'l RE buyers and sellers are mostly professional who have a high level knowledge of what they're looking for and negotiating transactions, and the brokers are far less important in the process. An internet marketplace for comm'l RE is as natural a niche as Amazon in the book business. The above posters are probably luddites pooh poohing technology that they perceive to be threatening their job.

LOOP is stepping up and competing with CoStar, and if you compare their business models its like GOOG vs. AOL ten years ago.

Chris raises very good points and some will prove to be true like you can't maintain a ridiculous growth rate. But others are misleading like higher churn rate. When you raise prices, you're definitely going to lose more customers but if total revenues increase significantly and the churn rate increases marginally that's a trade-off any businessman will accept. The bottom line is hard numbers; much of the above data is out of context without bottom line hard numbers which we'll soon see. In the meantime, the stock at current levels is a good but risky buy mainly due to whether the economy goes into recession and not the residential fallout. Right now the odds are plus or minus 50% depending on the crystal ball reader.

Stay tuned and don't panic. Remember the greatest fortunes are won during times of crisis when people do irrational things enmasse.

2008 Jan 08 10:28 PM

[Lexy:]

LOOP dipped into the high tens today. My question for everyone, esp. Chris, is what is your buy point and why? Seems like it's very undervalued now, but the selling continues.

2008 Jan 09 01:13 PM

[CCbroker:]

I am a licensed real estate broker. I have been a LoopNet premium subscriber for the past two years. First year my dues were $449, second year $674 and this year's renewal, the notice which I never received but was charged to my charge card, was $1799.40!!! I belong to a group of commercial brokers, which, as a group, has decided to boycott LoopNet. They are non-renewing and/or requesting cancellation of a prepaid annual membership with a credit reimbursed to the broker. We all feel we were reeled in only to be totally taken advantage of. This only substantiates the numbers above--members are signing on to view (at no cost) and after their initial sign on vist, may never return, but the premium members are dropping their paid memberships.

2008 Mar 11 01:00 PM

[Cyber Prope...:]

Attn: CCBroker. I agree with your sentiments and have just recently launched Cyber Property Exchange cprex.com. Its a free commercial real estate website service that does not charge a listing fee to search or post your listings. If you would like to forward my site to your Loopnet boycott group, please feel free to do so. Every user gets full access to all property listings for free! It has a save search capability with an auto notification system, you can forward properties directly to your clients, start a 1031 exchange and send a LOI directly to any property lister. I will be aggressively marketing the site in the very near future.

2008 Mar 13 04:21 PM