Zillow (Z) was one of 2013’s undisputed winners in U.S. equity markets, up nearly 200% year-over-year — handily beating the S&P 500 index and HW 30 housing economy index, both of which rose approximately 30% during the same time.
The company enjoyed huge success as the nation’s real estate markets sprang back from the doldrums last year, and as home price gains soared into the double digits, investors rewarded the company with a lofty price-to-earnings ratio reflecting expectations that the real estate search giant’s “living database” of 110 million U.S. homes could fundamentally change the real estate business.
But there’s a catch: all of the stock’s gains happened by September, and the stock spent most of the fourth quarter of 2013 giving back ground as investors began to reconsider if the company’s stock valuation had outrun what was actually reality.
And then, in early 2014, investors suddenly stopped worrying. In the first week of the new year, Zillow’s stock got hot again — jumping nearly 10% in just one week to close over $90 per share on Jan. 7.
This whipsaw effect on the company’s valuation has certainly been interesting in its own right, but the ride reflects the massively heavy stakes in play. The bottom line here is that the winner of the battle for the future of real estate marketing probably ends up looking a lot like Apple (AAPL).
We’re not kidding.
No wonder the crazy-high and speculative valuation here. But is Zillow really worth it? Let’s dig into both sides of the argument.
THE BEAR CASE
When a stock shoots up as fast and as far as Zillow did in 2013, it’s usually not because the company’s fundamentals are equally spectacular. And at Zillow, it’s certainly not current profits that have investors giddy.
The company posted a loss of $1.2 million in the third quarter of 2013, after posting losses of nearly $14 million during the first two quarters of the year. And while revenue continues to grow — at a 69% annualized clip through the third quarter! —the company’s leadership has to convince investors that revenue growth now will somehow equal substantial profits later.
It’s clear, however, that at least some insiders at Zillow are content to take their short-term gains off of the table now, rather than play long ball.
In the last six months of 2013, Zillow insiders sold a net 7% of their insider share float — the first time that insider transactions netted an outflow of shares over a half-a-year period. While in and of itself this shouldn’t trouble most investors, the fact that insiders are increasing their selling pace right after a huge run-up in stock value should at least raise some eyebrows.
That said, most investors don’t have a problem with the company’s current losses, as Zillow retains a whopping $365 million in total cash on its balance sheet ($9.37 cash per share). Nor do investors care too much if insiders take some of their holdings off the table when a company is growing revenue at more than 50% per year.
Their only real concern? Whether Zillow is grossly overpriced, at a whopping 185 times next year’s earnings (as of early January 2014).
The company’s nearest competitor, Trulia (TRLA), was trading with a 51.2 forward price-to-earnings ratio during the same time frame. And it’s rare to find a number two player in any large market that is trading at just 28% of the value assigned to the market leader.
Additional investor red flags are certainly easy to find, too. Zillow’s price/book ratio for the third quarter of 2013 came in at 6.32, versus 3.38 at Trulia. Investing traditionalists usually want to see this ratio below 5 and — if anything — investors have been pointing to data like this to suggest that while Zillow’s got a great future, the stock has run outside of reality.
This isn’t a minority view, either: short interest in the stock reached 49.9% of available float in December 2013, up dramatically from roughly 21% in early August.
THE BULL CASE
While bears worry, bulls profit. At least, that’s largely been the case in 2013 and looks to be how Zillow’s stock has been trading in early 2014, as well.
The reason is simple: traditional ratios and concomitant worries about market valuation have to be taken in context. And in this case, the context is mind-bogglingly massive.
Consider this: in 2012, Zillow and Trulia (the two largest firms in this space) combined to generate $185 million in revenue. Now contrast that performance against real estate agent commissions alone in the same year, estimated at $60 billion.
That means the two leading real estate marketing dot-coms were able to collect .3% — yes, just 1/3rd of a percent — of all real estate commissions.
It’s widely estimated that agents spend an estimated 10 to 20% of their commissions on marketing efforts, representing between $6 billion and $12 billion annually. Against those numbers alone, does Zillow’s market cap of $3.5 billion really seem so unrealistic?
I didn’t think so.
Interesting, too, is that basic math might be too low for the future we’re quickly headed into. Zillow’s management has said it believes total advertising levels among real estate professionals will rise to $20 billion or more annually. Betting that the clear leader in the online segment for real estate advertising won’t capture even 10% of that spend over time would seem to be a fool’s errand.
But here’s where it gets really interesting: Zillow is more than a place for Realtors to park their marketing dollars. The company has expanded its services, offering mortgage professionals a place to generate leads as well as building new tools around home rentals and home remodeling (Zillow Digs).
The nation’s housing economy is much larger than just the real estate agent commissions that Zillow is targeting a share of: in fact, it represents at least 18% of U.S. gross domestic product each year between private residential investment and consumption spending on housing services. We’re talking a lot of zeros in market size here.
These extensions put Zillow in the position of capturing dollars that go beyond just the real estate agent. The company is already making a run at the mortgage industry ($1.1 trillion/year or so) and the home remodeling industry ($300 billion dollars/year or so), for example.
The home remodeling industry alone supports two retail giants in Home Depot (HD) and Lowe’s (LOW).
Imagine what happens when Zillow eventually decides to use its Zillow Digs product to actually begin to directly resell the materials consumers see in the app? Who wins that fight: the old-line retailer or the dot-com that has the consumer’s eyeball and attention?
If recent history in other industries is any indication — from travel, to human resources, to movies and even traditional big-box retail, all industries that have been transformed by the digital experience — it’s wise to choose the dot-com winner, every time.
If Zillow can succeed in its gambit, the company’s market cap at even a $4 billion valuation would look cheap. But it’s still a huge if, and investors have been wrestling with just how risky a proposition Zillow’s business really is.
