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The internet real estate sector is one of the most crowded sectors in the market place and it seems like every other month another real estate website pops up. One explanation for this surge in real estate websites is the low start up costs associated with pulling data from the national real estate databases and presenting it in a user friendly layout. This data gathering and layout on a street view is essentially all websites like Zillow provide to the real estate shopper. But if you want to invest in something innovative, a business with a technology that cannot be replicated and revolutionizes a sector, this brimming online real estate data sector might not be the best way to play the housing rebound.

Zillow management and bulls claim that their current 90 Million in revenue from real estate agents represents less than 2% of the total yearly agent marketing spend. If that was true then there would be a lot of room to grow for Zillow and its dozens of competitors, but looking at some figures this market quickly shrinks. The National Association of Realtors (NAR) puts their current memberships near 1 Million on their website. Also according to the NAR's website the independent contractors total 81%, who are most likely the main users of online marketing tools to reach customers. The other 19% work for firms who have their own roads to market and marketing tools. Another fact that shrinks the agent market can be seen in the following video by RE/Max that says only 27% of real estate agents are full time. Next we take into account the monthly spend of Real Estate Agents on online marketing. The data by Activerain.com puts monthly marketing spend per agent at $664, which in all probability is that high only for the elite agents, but this is a very conservative model for the Zillow bulls, so we will leave it at that. So extending the monthly spend to a yearly spend we arrive at $7,968 per year. Per Zillow's 10-K they generated 90 Million from agents and claim that it's less than 2% of the spend out there, which would equate to about a 4.5 Billion market. Bringing us to the following chart, which shows a conservative estimate and a Zillow estimate. The conservative estimate seems more realistic because it limits the market to only half of the yearly spend on services like Zillow offers (agents don't put all of their eggs in one basket that is why the Activerain.com .pdf shows the many different marketing tools they use). It also assumes part time real estate agents spend half the amount full time agents spend, which might even be overstating their spend since part time agents include people with full time jobs and who do real estate part time for family and friends or on referrals.

(click to enlarge)

So using the entire budget as an estimate (all eggs in one basket estimate) the results still come in at around a 4.1 Billion market (the market spend data is from 2011 so let's assume a large 10% spending increase and we arrive at 4.5 Billion). A betting man would venture to say that the part time agents spend next to nothing on advertisements and just rely on word of mouth and repeat business, but we will remain ultra conservative in these models. Thus the conservative estimate with yearly spending growth factored should be somewhere around 870 Million, which is only 19% of the Zillow estimate.

That being said that brings us to our next model, based upon a statistic in the Activerain.com marketing data, which says 42% of business comes to agents from referrals, past clients and personal websites. So we now co me to the realistic model, taking away this 42% who are doing just fine on referrals and past clients, that leaves roughly 58% of agents needing outside tools to generate business. Also using Zillow's 10-K, and my conservative model of the potential available agent revenue of 2.3 Billion, their year over year growth was only 0.2% of the available 2.3 Billion market. This is seen by them growing agent revenue of 42Million in 2011 to 86 Million in 2012. Thus they currently represent 3.7% of the total 2.3 Billion market and say they keep doubling that growth rate for the next three years, we come to the next three yearly growth rates of 0.4%, 0.8% and then 1.6% (ending at 6.5% of the market in 2015).

This is a more realistic model because the street might soon figure out that the market for agent revenue is 25-50% of what was originally claimed and even with a very high and unlikely (due to competition) growth rate of 26% for their online web traffic revenue, their 2015 projected EPS would still be at $0.20. That represents a growth rate of only 11% from 2012 to 2015, or 3.67% yearly EPS growth. Of course Zillow has realized this and is now looking for additional revenue streams via partnerships, mobile expansion and their controversial Digs service. Thus even if all of these new ventures add some EPS (they can easily cost them EPS as well), it would still not be enough to justify where the company is priced today. I have included the price targets based on the different P/E ratios. The P/E of 25 is in green because it is more likely for a company that is slowing down in growth and becoming an established company.

(click to enlarge)

Next the bull case must be represented as well. Zillow claims there is a 4.5 Billion yearly marketing spend by agents that they can go after and they currently have 86 Million of it. The 86 Million equates to 1.9% of their total market and they grew it from 2011 to 2012 by 1% of the total market. So let's keep doubling their growth in their model and let's throw out an insane number and say they grow 88M, then double to 176M and then double again to 352M in 2015, which equates to 3.86% of the market in 2013,7.8% in '14 and 15.6% in '15. Using these extreme growth models, which will likely never happen with the amount of competition in this sector, the 2015 EPS should be $0.71. This represents an 18% yearly growth from the current EPS of $0.18. The reason I point this out is that currently the P/E of Zillow is 339 due to the market giving the company a "growth" label. This growth label is usually reserved for startups with a unique technology that yields astronomical growth or an innovative process that offers a company a unique foothold on their industry. Zillow might have had this when they first started, but with the influx of competition and a limited market, the growth rate will fall too below 20% even on the most aggressive models like the one below:

(click to enlarge)

A couple of other troubling things to watch out for in the future are pointed out in the following Inman.com article. The article states that although the agent subscriber rate is up, Zillow refuses to publish the churn or turnover rate. This hides the turnover rate and makes it hard to say if the agents are sticking around from the benefits of Zillow or trying it out and not finding a lot of value in it. One possible reason they are hiding this rate is the accuracy of their stats turning a lot of agents away. According to this ZipRealty report, "16% of the home listings shown on Zillow's website were not listed by the corresponding MLS to be for sale at the time of their display on the Zillow website." ZipRealty also claims they list properties 92 days faster on average than Zillow, which would frustrate any agent who likes current housing listings. Another worrisome fact from the Inman.com article is that Zillow is doubling their advertising budget, thus the growth is spurred on by this aggressive marketing spend, which is helps to explain why their profit margins are at a low 5%. If they try to let up on the advertising to get their margins up, what will that do to website traffic and agent subscriptions? Given these two worrisome facts and with competition on the rise, it might be hard for them to meet their growth targets and get their P/E ratio under 100, which investors are looking for.

One of the last things to always look at are the past few quarterly results as well as key financial data of the companies in this sector.

Zillow (NASDAQ:Z)

*all revenue / income numbers in thousands

 

2012Q4

2012Q3

2012Q2

2012 Q1

Revenue

34,337

31,915

27,765

22,833

% Variance

8%

15%

22%

 

Cost of Revenue

3,806

3,623

3,264

3,350

% Variance

5%

11%

3%

 

Net Income

549

2,334

1,332

1,724

% Variance

-76%

75%

-23%

 

EPS Estimates

Low

Mid

High

Forward P/E (w/midest.)

2013

0.25

0.33

0.45

188

2014

0.6

0.8

1.11

75

Total Debt /Equity

0

   

Operating Cash

32Million

   

Total Cash

194Million

   

Trulia (NYSE:TRLA)

*all revenue / income numbers in thousands

 

2012Q4

2012Q3

2012Q2

2012 Q1

Revenue

20,554

18,544

16,825

12,162

% Variance

11%

10%

38%

 

Cost of Revenue

2,691

2,615

2,488

2,205

% Variance

3%

5%

13%

 

Net Income

-1,592

-1,689

-3,440

-4,200

% Variance

6%

51%

18%

 

EPS Estimates

Low

Mid

High

Forward P/E (w/midest.)

2013

0.15

0.19

0.26

173

2014

0.62

0.74

0.94

44

Total Debt /Equity

11.55

   

Operating Cash

4 Million

   

Total Cash

100Million

   

zipRealty (NASDAQ:ZIPR)

*all revenue / income numbers in thousands

 

2012Q4

2012Q3

2012Q2

2012 Q1

Revenue

17,692

19,767

20,288

16,073

% Variance

-10%

-3%

26%

 

Cost of Revenue

10,056

11,170

11,099

8,336

% Variance

10%

1%

33%

 

Net Income

(1,995)

(4,940)

314

(3,057)

% Variance

60%

-1673%

110%

 

EPS Estimates

Low

Mid

High

Forward P/E (w/midest.)

2013 (n/a)

    

2014 (n/a)

    

Total Debt /Equity

0

   

Operating Cash

-7Million

   

Total Cash

27Million

   

Move Inc (NASDAQ:MOVE)

*all revenue / income numbers in thousands

 

2012Q4

2012Q3

2012Q2

2012 Q1

Revenue

52,737

49,446

49,309

47,741

% Variance

7%

0%

3%

 

Cost of Revenue

11,904

10,236

9,628

9,645

% Variance

16%

6%

0%

 

Net Income

1,588

1,785

1,420

-110

% Variance

-11%

26%

1391%

 

EPS Estimates

Low

Mid

High

Forward P/E (w/midest.)

2013

0.13

0.16

0.18

71

2014

0.38

0.41

0.43

28

Total Debt /Equity

0 debt

   

Operating Cash

29Million

   

Total Cash

27Million

   

Realogy (NYSE:RLGY)

*all revenue / income numbers in thousands

 

 

 

2012 Q4

2012 Q3

2012 Q2

2012 Q1

Revenue

1,207,000

1,281,000

1,309,000

875,000

% Variance

-6%

-2%

50%

 

Cost ofRevenue

956,000

969,000

987,000

720,000

% Variance

-1%

-2%

37%

 

Net Income

-292,000

-34,000

-25,000

-192,000

% Variance

-759%

-36%

87%

 

EPS Estimates

Low

Mid

High

Forward P/E(w/mid est.)

2013

1.03

1.52

1.89

47

2014

1.89

2.41

3.02

26

Total Debt /Equity

306

   

Operating Cash

-103Million

   

Total Cash

376Million

   

One thing all of these stocks have in common is that their 2013 and 2014 growth projections, compared to their current share price, still pegs them at a P/E ratio between 25 and 100. Thus extending my Zillow models, the entire industry is still overpriced and should be adjusted for growth rates under 20%. Since all of these stocks offer very similar products, it seems like they are all being artificially lifted by everyone trying to play the housing rebound somehow. Look at all of their last several quarters, the revenue for these companies has been either declining, flat or growing slowly. The cost of revenue for most of the companies has been increasing as well and the net income has been abysmal, further strengthening the bear case on this sector. One explanation of the unimpressive results is that more and more competitors are vying for the limited amount of real estate agents as well as web site traffic. Lastly, a lot of them have debt, low cash flows, low cash on hand and low earnings per share, thus it will be hard for any of them to distinguish themselves from the pack with such small amounts of cash on hand without issuing a lot more new shares and diluting their share value.

The run up in share price for Zillow and this sector as a whole seems to be largely based on the hope that real estate will be back to the extraordinary levels before the collapse in 2007. But we now know that with a lot more rules and regulations in the industry and with the investment banks being restricted from making wild bets on highly leveraged low rated loans, the real estate industry will likely not be back to 2007 levels anytime soon. We also know that the Fed has helped to artificially prop up the economy by printing records amount of new money through a process called economic easing. On top of this fact, the record low interest rates are fueling big banks and investment firms to buy up property. So in about a year when the Fed plans to stop economic easing, the rates should go back up and when the investment firms turn around to try to sell their properties, how will the real estate market look then?

One of the last things to analyze before concluding is the competition and possible future competition. I have listed just several of the leading companies in this article, but there are a lot more including Redfin (planning to go public in 2014), Movoto, Craigslist, Coldwell Banker, RE/Max, etc. The competition is so great and vast, it is very hard to distinguish oneself from the dozens of other companies who offer virtually the same products and services. Not to mention that major internet companies who employ a lot of programmers (remember that most of these sites mainly run on data gathering, programming to display that data and a sales department) like Yahoo (NASDAQ:YHOO), Amazon(NASDAQ:AMZN), Facebook (NASDAQ:FB), Microsoft (NASDAQ:MSFT) and Google (NASDAQ:GOOG) can come into this market space at any time. One company that could essentially cripple most of these internet real estate database sites is Google. The companies analyzed in this article live off of their websites being on the first page on the Google search engine. If Google wanted to combine its powerful Google Maps and Google Earth products to offer a way for a user to browse a 3D neighborhood and to see what properties are available to purchase, it would not have to go through a lot of its 50 Billion in cash to make it happen. They would also promote their product and any properties searched on Google would have their Google real estate product as the first hits on the results page. So analyzing the amount of competition and realizing that major web companies can enter at anytime, should caution anyone thinking of buying a share of a real estate search engine stock with a high P/E ratio. With this in mind, the safest bet if someone really wants to enter this market segment might be to invest in one of the lower forward P/E companies, like Move Inc., Realogy or ZipRealty.

In summary, the current price per earnings and share price of Zillow and its competitors are in the stratosphere. They can only be explained by investors playing the possible real estate bounce back aimlessly or playing a possible short squeeze on small market cap companies. Zillow's 2013 and 2014 projections, while appearing to be large percentage increases on paper due to bouncing back from low gross incomes, will still yield very low earnings per share and possible slow growth. The price per earnings ratio will still be high going forward, much higher than the Dow and S&P components, thus you must ask yourself what are you really paying for? The volume traded on these stocks is very low and some would consider these very speculative and extremely risky. A cautious investor would wait 3 to 4 quarters of positive revenue growth above 20% and solid margin growth. If that happens, and that is a big if, I would still never buy a share of a company with a P/E ratio above 40 in this sector. This sector is very susceptible to the economy, has little to no unique or proprietary technology and is one of the most competitive sectors tied to a volatile and uncertain real estate industry.

Source: Zillow's Faulty Agent Estimate, Growth Model And Stock Price

Additional disclosure: This article is purely my opinions and speculations and is not meant to influence the stock price