Real estate focus helps Homestore turn the corner. (Up Front).

Homestore Inc. may yet make it.

With a lot of fence mending and a bit of luck, the troubled online real estate services provider is on the cusp of survival.

The Westlake Village-based company turned an operating profit of sorts in the third quarter, and its management is working through the legal disputes that have cast a shadow over the company since it revealed $192 million in bogus revenues earlier this year.

It's also put together a new product and pricing strategy that is getting good reviews from its main client base, real estate agents, and it has cut its cost base to levels that are near sustainability.

"There's no question about it, they're at a very critical junction in their future," said Jack Ehnes, chief executive of the California State Teachers Retirement System, lead Homestore shareholder in a consolidated class action lawsuit against the company.

"Here's a company with a very good product," operating in a successful niche with strong customer relationships, Ehnes said. "On the surface, those things would suggest a very good business plan."

Homestore dominates the online real estate listings category. According to the company, 70 percent of Internet users researching homes or apartment rentals on third party Web sites come to Homestore. The company has sewn up deals with hundreds of regional multiple listing services that are members of the National Association of Realtors.

New management, led by chief executive Mike Long, has improved Homestore's relationships with agents and with the NAR, whose Realtor.com Web site is run by Homestore. Long has made adjustments to the way Homestore packages and prices its products and services, which are sold to real estate agents.

"We're very pleased with the new management," said Steve Cook, vice president of public affairs at the NAR. "The company's much more focused on the real estate business than it was before."

AOL dispute

Of course, there's still some baggage. Three former executives have pleaded guilty to criminal charges of helping book false revenues. The company is still bleeding cash, although the amounts are getting smaller each quarter.

The big shadow is a pending dispute over an April 2000 marketing agreement struck with America Online, now a unit of AOL Time Warner Inc. If the agreement withstands an arbitration challenge by Homestore, the deal could force the company to hand over 46 million of its shares to AOL - or, alternately, to pay out so much cash that Homestore would wind up essentially broke.

The arbitration case, which hinges on whether AOL fulfilled its part of the bargain, was heard in July. A decision is expected by the end of the year. Meanwhile, the companies are negotiating a possible settlement that could be reached before the arbitration decision is made.

Last Thursday, Homestore stock jumped 44 cents, or 40.4 percent, to $1.53, as speculation mounted that a settlement of the AOL matter was near, spurred by revelations contained in an amended shareholder class-action lawsuit against Homestore.

"Maybe they both want to see (the arbitration) go to bed," said a source familiar with the arbitration but not privy to the status of negotiations.

The amended shareholder suit names AOL and another large Homestore partner, Cendant Corp., as participants in Homestore's alleged fraudulent scheme. It also details the involvement of AOL executives in setting up the bogus deals.

The source said that the new disclosures could weaken AOL's position in the arbitration dispute, giving AOL an incentive to settle.

Homestore officials didn't return calls.

"Both Homestore and AOL have expressed a desire to create a basis for a new relationship going forward at the completion of this (arbitration) process," Long said on Homestore's third quarter conference call. "These discussions are very preliminary but could result in a negotiated settlement prior to the receipt of the arbitrator's decision."

AOL Time Warner spokeswoman Tricia Primrose declined to comment on any possible settlement.

Lilting a burden

If Homestore wins the arbitration case, or succeeds in negotiating a reduction of its commitment, a huge burden will be lifted. If it loses, the company could wind up paying the $92.5 million it has already pledged toward satisfying the AOL agreement, plus an additional $70 million or so in cash or stock, by next July.

Making the cash payment would take up nearly all of Homestore's remaining cash - the company estimates it will end the fourth quarter with between $75 and $80 million in unrestricted cash.

So it's likely that Homestore would choose to issue stock, however unsavory such a move might be. Based on current prices, AOL's stake in Homestore would rise to more than 50 million shares, or more than 30 percent of all shares outstanding, when the deal's first trigger hits next July.

A potential share issuance would also dilute, to the tune of about 40 percent, the holdings of Homestore's existing shareholders. As a result, even the shareholders suing Homestore have common interest with the company when it comes to Homestore's dispute with AOL.

For CalSTRS, which lost $9 million on its Homestore investment, the larger concern is addressing the substantial corporate governance issues that the Homestore case raised.

Now that CalSTRS has assumed the "bad cop" role in going after AOL and Cendant, Homestore has an unspoken ally as it tries to mend fences with these powerful partners. Ehnes denies any coordinated effort by CalSTRS to help Homestore against AOL and Cendant. He also denies any "deep pockets" strategy in naming the two larger companies, as well as Homestore's accountant, PricewaterhouseCoopers.

Besides the AOL matter, Homestore officials have been working on a settlement with Cendant, which controls the Century 21, Coldwell Banker and Era real estate franchises. In the second quarter, Cendant said it believed Homestore breached certain agreements between the two companies, and the companies have been negotiating for changes in their ongoing agreements, which provide for purchases of Homestore services by Cendant affiliates.

If and when these lingering legal issues are resolved, Homestore's brass faces the challenging, yet manageable, task of operating its business.

Despite a reported loss of $39.8 million in the third quarter, Homestore generated income from operations of $722,000, after restructuring charges and non-cash charges for depreciation, amortization and stock grants were backed out.

On a comparable basis, the company lost $8.4 million in the second quarter of 2002, and $33.8 million in the third quarter of 2001.

Company officials declined to project fourth quarter results, because so many changes are taking place all at one time. But one major shift has been a new pricing strategy that allows real estate agents to unbundle Homestore's offerings.

An agent that wants to set up his or her own Web site, and just have access to the Realtor.com listings, can pay less than, say, an agent whose Web site is hosted by Homestore lock stock and barrel.

Homestore has also moved to a subscription model for its main software package, providing an online service for a monthly fee rather than selling a software bundle all at once at a higher price. In the two months the package has been sold in this way, demand for the service is tracking at four times the rate of the previous bundle, Long said.