ZILLOW INC Z S
August 09, 2013 - 10:29am EST by
mm202
2013 2014
Price: 89.50 EPS -$0.04 $0.57
Shares Out. (in M): 35 P/E 0.0x 157.0x
Market Cap (in $M): 3,093 P/FCF 0.0x 0.0x
Net Debt (in $M): -144 EBIT 0 0
TEV ($): 2,949 TEV/EBIT 0.0x 0.0x
Borrow Cost: NA

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  • Real Estate
  • Online Advertising
  • Misunderstood Business Model
  • Insider selling
  • Rollup
  • Poor Investor Communication

Description

As a follow-up to an insightful yet ill-timed short write-up by Birdie11 last November, I am presenting Z as a timely and compelling short. I recommend Birdie11’s write-up for a comprehensive background on Z’s business, which I will not recreate here.

 

Not only is Z an extraordinarily expensive stock, but I believe that it has been awarded a valuation generally reserved for only truly disruptive and dominant companies, when in fact it is very far from that sort of company and has a business model that has never proven effective for either Z or its competitors.

 

Since this is valueinvestorsclub, I’ll start with discussing Z’s nosebleed valuation, though I don’t think even the company’s most ardent supporters would argue the point that Z is extremely expensive.

 

The average 2014 earnings estimate for the company currently stands at .59.  Z therefore trades at approximately160 times this forward estimate.  The consensus analyst estimate for the company’s 2014 revenues is $259 million. With a current market cap of 3.07 billion, Z trades at about 12 times those projected 2014 sales.

 

I’m not going to belabor the point- this is obviously an extremely expensive stock by any measure. I would contend that, even if Z were a truly superlative company with extraordinary growth potential over the next several years and monopolistic control over its market niche, buying the stock at that sort of valuation would be a very poor risk/reward proposition. However, Z is very, very far from such a company as the remainder of this write-up will address.

 

It seems fairly clear that the massive year over year rebound in the housing market has had a lot to do with Z’s meteoric price rise in that timespan. Z seems to be perceived as a high-tech way to play the housing rebound, with the ability to scale its business impressively over time while keeping expenses low and margins high that some other market darling internet stocks possess.

 

The reality, however, is very different.

 

To understand why, you have to understand Z’s business model.  But before we get into that, let’s take a step back and consider that companies have been generating internet leads for realtors for more than 15 years. Keep in mind that MOVE.com (formerly Homestore.com), a company with essentially the same business model as Z, couldn’t operate profitably in the real estate boom of the mid 2000's. Even though MOVE was the sole online destination for brokers to buy leads MOVE’s stock was decimated, with MOVE going from over a 2 billion dollar company to a 540 million dollar company today.  Similarly SOLD (now LEDR), which also operates essentially the same business as Z, lost approximately 80% of its market capitalization from peak to trough. The decimation of MOVE and SOLD’s stock prices occurred as investors realized that the business model of selling leads to real estate brokers is extremely difficult to scale. It remains so today, only even moreso due to the presence of multiple competitors.  

 

Speaking of competitors, MOVE currently trades for about twice projected 2014 sales..roughly 1/6th the price/sales ratio of Z.   LEDR trades for about 4.5 time projected 2014 sales. Even upstart TRLA, which by any measure is an extremely overpriced stock in its own right, trades at “only” 9.5 times projected 2014 sales and a tremendously lower forward PE relative Z at “only” 60 times projected 2014 earnings of .74 (which compares favorably to estimates for Z to make .54 per share, even though Z has more than twice TRLA’s market cap).

 

 

Now to Z’s business model- almost all of their revenues are derived from realtors who subscribe to their service so that Z will give them leads. In order for Z to deliver those leads- and keep realtors as paying customers- they have to drive customers to their site. Now the company has been doing a good job of increasing its pageviews. BUT they have been spending a ton of money on advertising to do it, and the company has admitted that the number of leads they are generating for their broker customers has essentially remained unchanged.  The upshot of these disturbing trends can be clearly seen in their last earnings report, in which they reported dramatically decreased margins (Ebitda margins plummeted from 19% in the second quarter of 2012 to 11% in the just-released Q2 2013 report) and resultingly reported a much greater than anticipated loss (despite beating on revenues). Following the report, the stock sold off sharply and imho this was a very rational reaction as I believe that this report will be seen in retrospect as the “beginning of the end” for Z…as the point at which it started to become obvious that Z operates a very low margin business.  On the post earnings conference call Z’s CEO admitted that subscribers were still getting the same 10-20 leads per month despite Z spending so much on advertising to drive pageviews.  This explains why margins dropped so much, and it also explained why Z has indicated that it wants to focus on expanding into the rental space. As with Z’s acquisition binge (discussed later) this focus on rental business is another “tell” that the company knows that its existing business is a very difficult one, with very low margins. Of course, the rental space is also very crowded and includes numerous regional competitors as well as free competitors like craigslist.

 

Not only is the company is paying through the nose to drive additional customer volume to their site but, as Birdie11 set forth compellingly in his write-up, it also appears very likely that the low  hanging fruit has already been picked in terms of Z signing up paying realtor customers. Z is not a new company. It has in fact been around for roughly 7 years and has never made a full year profit, nor been cash flow positive in any year (in most years it hasn’t even come close). Realtors are well aware of the service Z provides and I see no reason to suspect that there is any realistic chance of Z becoming suddenly immensely popular with realtors when they are offering the same service they’ve been offering with unimpressive results for 7 years. Not only is Z’s business essentially the same as it always has been, but competition in Z’s niche has significantly intensified recently, as Birdie11 pointed out in his write-up (competitors include TRLA, MOVE, realtor.com, LEDR). Z’s business has very low barriers to entry and there is very little to distinguish Z’s site from that of its competitors. Even worse, there has been substantial realtor backlash against Z’s “zestimates” of home price values, which from all accounts tend to be largely inaccurate (reportedly, 17% of Zestimates are more than 24% incorrect). 

 

Acquisition binge

 

It should be noted that Z has been on an acquisition binge as of late, acquiring Rentjuice, Mortech and Hotpads. These acquisitions have contributed significantly to Z’s revenue growth but imho they represent an acknowledgment that Z’s core business does NOT have impressive long term growth prospects, for the reasons detailed above.  The same can be said for the prodigious amount of recent selling by company insiders.

 

Insider selling

 

Z insiders have sold roughly $120 million of stock in the last year, which represents yet another red flag. My view is that Z insiders realize that the company’s prospects are nowhere near as bright as the recent stock performance would suggest, and are therefore happy to cash out at current nosebleed levels.

 

I've certainly seen companies with even more insider selling. However, Z has demonstrated a concerning disregard for shareholders in at least one of their prior offerings. The best example of this comes from their offering in September of last year. In their August conference call they essentially said that they were filing a shelf just as a matter of "good housekeeping" (see management's comments below, taken verbatim from the quarterly conference call), strongly suggesting no immediate plans to raise money. And then the company sold shares to the public pursuant to the shelf as soon as it became effective, with insiders cashing out $22 million as part of that offering. This raises a red flag in my view as to Z management's transparency and regard for its investors (as does the  lack of disclosure regarding churn which is addressed below).

 

Chadd M. Cohen CFO:

"On August 1, we became S-3 eligible and today filed the shelf with the SEC as

a matter of good housekeeping and to provide ourselves with flexibility on

our capital structure in order to remain prepared for future considerations of

both our operational needs and potential strategic opportunities in the

marketplace."

Spencer Rasckoff, CEO:

" So basically…a year after being public, as a matter   we filed the shelf, which is pretty much customary for

companies at this stage… So, just to be clear for those on the call who maybe

don't know that there's been a shelf and a follow-on, what we filed today is not

a follow-on offering… It’s a shelf statement with the SEC, which says, basically

it registers shares… So if we decide to do a follow-on later, then the shares

can be sold more rapidly; basically we can complete a follow-on more

expeditiously… you're supposed to file what you think is reasonable to sell

over a two year period potentially, and so that explains why we chose $150

million… Again, it’s a pretty customary thing for a company on the one year

anniversary post IPO to do this just so you can do a follow-on, if you choose,

and we have not decided whether or not to do a follow-on, if you choose, more

expeditiously, and we have not decided whether or not to do a follow-on."

 

 

 

 

Refusal to disclose churn rate

 

The SEC last year called on Z to disclose the churn rate of its customers, something that it has yet to do. I believe that it likely refuses to do so because the churn rate, if revealed, would paint an unflattering picture for the company. As birdie11 detailed in his write-up, there is significant anecdotal evidence of Z alienating its realtor customers by, among other things, (1) providing often egregiously inaccurate “zestimates” of home values which makes realtors’ jobs harder, and (2) by sharing their leads with numerous realtors in the same territory (thereby reducing their value to each paying realtor). Complaints such as the one relayed by the realtor quoted below are apparently common, and therefore it seems reasonable to assume that Z’s conveniently undisclosed churn rate is likely troublingly high:

 

“I have used Zillow for my marketing with 3 zipcodes. I have slowly cancelled all but one zip codes. I have had a closed transaction.So It kinda worked. That said there is no consistency in leads and quality of leads. I used to have a larger market share for each territory. My exposure is being diluted by the increase in volume to the site. Zillow sells more advertising to more agents in my area. So Its kind dilutive unless you pay more for advertising. I suspect other realtors are feeling the same pinch and while I suspect this will work for zillow in the short term. I am not confident about the long term. If this continues. I will discontinue my marketing at Zillow. As there are other sources at better pricing.
Be happy to explain in more details if needed. I suspect having a valuation of 10-15 times sales if lofty. I suspect there churn rates will start to go up in near future. Just my inside view.

http://bit.ly/17wyx9S

 

Overly optimistic growth projections

 

Analyst estimates expect a 38% revenue increase for Z from 2013 to 2014.  While I believe that Z would be egregiously priced even if these robust growth projections were to be met, I believe that there is a very high likelihood that they won’t be, with disastrous consequences for Z’s stock price.  Leaving aside how competitive the space is and the large number of anecdotal reports re unhappy Z realtor-customers, there are additional reasons to view these growth projections suspiciously.  Once again, keep in mind that this company has been operating since 2006 and has been cold calling virtually every active realtor monthly for years. So almost all realtors are well aware of the service they offer, which begs the question- if a realtor hasn’t already subscribed, what’s going to make them start now?  Particularly with competition dramatically increased and when the company admits that the quality of the leads they provide has remained essentially the same despite their increased advertising efforts.

 

MOVE was the market leader up until a few years ago, but lost that position due in large part to the lack of complete listing information. High foreclosure rates that were in evidence following the housing crash very likely drove significant additional traffic to Zillow’s and Trulia’s sites, as these sites included listings for properties that competitor MOVE did not list. Because of an agreement with the National Association of Realtors., MOVE was not able to list a myriad of properties that included foreclosures and other non-realtor listed homes and apartments.  Two weeks ago that changed as the NAR in a special board meeting agreed to lift the restrictions on what MOVE could list to better able the site to compete with Zillow and Trulia.  Basically, realtors decided they’d had enough.  By the way, this is the first special board meeting by the NRA since 1996.  Clearly they saw that they had a problem with Zillow, Trulia, Redfin, etc. and decided they need to do something about it.  The NAR in a statement said they were committed to “making realtor.com® the first, best online destination for home buyers and sellers.”

 

In addition, while housing prices are still rising significantly, it appears likely that the pace of new home sales has begun to moderate and will not maintain the furious pace that it has been seen in the last year as the housing market emerged from crisis and caught fire. June saw a drop in existing home sales as mortgage rates rose.  This also could contribute to Z missing wall street revenue estimates.

 

 

 

 

 

 

 

I do not hold a position of employment, directorship, or consultancy with the issuer.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

1). Continued margin erosion and/or disappointing revenue growth causes wall street to wake up and see that Z’s massive valuation multiple is completely unjustified.
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