Real estate is back and nearly every housing-related stock has seen significant improvement over the past two years. Homebuilders (XHB) have benefited immensely, alongside home improvement chains Home Depot (HD) and Lowe's (LOW), as well as building supplies makers such as Masco (MAS). Real estate website operators Zillow (Z) and Trulia (TRLA) have been no exceptions to this rule, with Z up over 125% and TRLA up almost 80% in a 12-month timeframe.
Of course, there's more to these two companies than merely a real estate rebound. Both Zillow and Trulia are high-growth firms looking to transform the way the real estate market works. That's why both companies have become a fascination amongst investors.
I agree with the growth thesis on a basic level. Jeff Chmielewski presents a great argument that a recovering housing market bodes well for both, and both sites saw their prospects lag a bit due to the housing market collapse during their early years. On the other hand, I don't think there's any way to possibly justify the valuations for either firm, even in a best-case growth scenario.
In this article, I want to make the case that Zillow is one of the most overpriced stocks on the American markets right now. I could pen a similar article for Trulia, but I think Zillow provides more juicy material.
1. Few Companies Have Been Cheap at Over 20x Revenues
Based upon its last four quarters, Zillow now sells at 23 times revenues. Very few publicly-traded companies have turned out to be good investments at over 20x revenues. The simple truth is that it's difficult for a company to 'outperform' the broader market with such huge expectations priced into the stock already.
It's not completely impossible, mind you. Apple would've been a great investment at almost any price in 2000. Of course, that was a turn-around story where Apple introduced wildly successful new products that the market had not anticipated. That seems very unlikely here.
Google is another great example. At the end of 2005, Google traded at 22 times revenues (thanks to an assist from Conor Sen for this info nugget). We can examine the company and the stock over the 7-yr period from the end of FY 2005 to the end of FY 2012.
As you can see, Google achieved annualized growth of 35% in revenues, 29% in operating margins, 33% in earnings, and 30% in earnings per share. That's an astounding track record over a 7-year period and you'd hard pressed to find many companies in the US over the past few decades that could match that.
In spite of that otherworldly run of growth, Google's stock achieved a modest 6.8% annualized return over that same 7-year time frame. It's a respectable return given that the S&P 500 only returned 1.9% annually over the same period, but it's not the 'blow-you-away' type of returns that might be implied by 30% annual earnings growth. Indeed, if you invested in a 7-yr treasury bond at the same time, you would've generated a 4.32% yield.
In other words, if you invested in one of the most wildly profitable and rapidly growing companies of the past century at 22x revenues at the end of 2005, you would've slightly outperformed a 7-year US treasury bond. It's not bad, but it speaks to the type of expectations that are already priced in at over 20x sales.
It's difficult to nearly impossible to meet expectations at this sort of valuation. Unfortunately, Zillow also does not look anything like Google.
2. Sales & Marketing
On the face of it, Zillow may seem like a prototypical game-changing tech company. In reality, Zillow is a low-tech sales organization. Citron Research made this very point in their negative report on Zillow in September 2012. Citron may be a bit overly bearish on Z, but they are correct about Zillow when it comes to sales generation.
Zillow generates most of its revenues from real estate agents. It often does so by calling them on the phone. While Z's sales expenses have varied over time, they have generally bounced around in the 40% to 60% of revenue range. In the most recent quarter, sales expense was 51% of revenues.
There's nothing wrong with this business model per se (my view differs from Citron's significantly on that point). It's just that it's not the type of business that you'd generally want to pay 23 times revenue for. There's a major difference between a company like Google and a company like Zillow, and that brings me to the next point.
3. Zillow Lacks Operating Leverage
Operating leverage is a very important concept in valuation. For a company with high operating leverage, a very large chunk of every incremental dollar of revenue goes directly to profits. Whereas, a company with low operating leverage would likely need to spend a large amount (e.g. 90 cents) to generate a $1 of revenue. The key issue here is fixed costs vs. variable costs. Businesses with high operating leverage are characterized by high fixed costs and low variable costs.
As an example, consider Netflix's (NFLX) streaming service. Let's say Netflix pays $8 million for all of its content and spends $2 million on the technology to develop its offerings. For every new customer, it also has $1 in variable wage expenses and Netflix offers its streaming service for $5. In essence, Netflix makes $4 of profit for every $5 of revenues, but has a fixed cost hump to get over first. Let's do an example.
In Scenario #1, Netflix gets 1 million customers. That's $5 million in revenue versus $10 million in fixed expenses, and $1 million in variable expenses for a total loss of $6 million. Netflix looks very bad in this scenario, but that's only because the number of customers is too low. With more customers, things dramatically improve.
In Scenario #2, Netflix gets 10 million subscribers. That's $50 million in revenue, but the fixed costs stay the same at $10 million. The variable costs increase to $10 million. That leaves Netflix with a $30 million profit. Netflix's profit margin went from -120% to +60% with the addition of 9 million customers, but not every business works that way.
The point of these scenarios is to showcase that for each incremental dollar of revenue NFLX generates, $4 of that goes directly to the bottom line. Thus, in this example, Netflix has a high degree of operating leverage. (Netflix's model in the real world is similar, but one big issue is that content providers can jack up prices - and hence fixed costs - over time.)
Zillow looks very little like Netflix in the example above. Zillow relies upon sales staff to make most of its revenues. As I pointed out in the previous section, about 50% of Z's revenues go towards sales and marketing. Add in the general and administrative expenses and you're already eating up somewhere from 60% - 75% of each new dollar of revenue. Then, another 5% or so is going to share-based compensation.
Technology and development (currently around 22% of revenues) may be one of the few areas where Z has some operating leverage. One might argue based on this (and a few other expenses) that Z has moderate operating leverage, but that's a best case scenario and it's certainly a far cry away from Google (i.e. the search engine), LinkedIn, Netflix, or even OpenTable.
Once again, this isn't necessarily bad. The mass-retailer Wal-Mart (WMT) and consulting giant Accenture (ACN) are two great examples of highly successful firms with lower operating leverage. Both are excellent firms, but you wouldn't want to pay 20x revenues for a firm with that type of business model. I can't see any rationale how Zillow can justify at 23x sales valuation with low-to-moderate operating leverage.
4. Cash Flow Negative
It's not totally shocking that a young firm would be cash flow negative, but when you combine it with the three aforementioned factors, it becomes a bigger head-scratcher. Remember, Google was wildly profitable at the end of 2005 when it sold at over 20x revenues, and its free cash flow picture was even more desirable.
Zillow's cash flows, on the other hand, have not looked very good.
Operating cash flows for Zillow look attractive on the face of it, but they are also a bit misleading. For one, the two big items propping that figure up are depreciation / amortization and share compensation expense. The former is almost always offset by capex. While share compensation expense is technically a non-cash expense, it does dilute the value of the stock, therefore I tend to exclude it from cash flow calculations.
Then, you also have to factor in a large string of acquisitions in 2011 and 2012. Acquisitions have become Zillow's main source of capex at this juncture. Once you examine these factors, Zillow has never really been cash flow positive and their best year was 2011 with a cash flow loss of $2.5 million.
As I've said in every section thus far, this capex driven model is not necessarily bad and many young businesses have negative free cash flows. At the same time, I can't understand why I'd pay 23x revenues for this type of unproven business model, especially when a massive amount of capex is going towards acquisitions.
5. Skepticism About Acquisitions
Speaking of acquisitions, we ought to take a look at those. Zillow has been on an acquisition spree, buying RentJuice for $38 million, Mortech for $12 million (and stock), and HotPads for $16 million in 2012. As with most things in this article, it's not necessarily a case of whether acquisition-driven growth is good or bad, but that (A) it tends to be riskier than organic growth and (B) it's more difficult to earn an "abnormal profit" from acquisitions.
When I say "abnormal profit," I am suggesting that it's difficult to earn an extremely high internal rate of return ["IRR"] on an acquisition, whereas, I'd wager to guess that tech firms like Google and Apple have encountered situations where organic investments had projected IRRs of 50%+.
Whether the HotPads and Rent Juice acquisitions were smart for Zillow is a good debate to have, but the bigger point and theme that I continue to hammer: why would I pay 23x revenues for this type of business model? Does Zillow have such a huge advantage in acquiring companies at discount prices, and then integrating them in wildly successful fashion, so as to justify a 23x sales valuation? Probably not.
There are a lot of companies that do acquisitions well, but they almost never get assigned a huge sales multiple, like a high-tech firm primarily driven by organic growth. To put it simply, acquisition based growth is not "cheap" and there is much less low-hanging fruit.
Another big issue with the Zillow story is competition. Obviously, there's Trulia, but there's also Move (MOVE), which runs realtor.com, and Redfin. This distinguishes Zillow from companies like Facebook and LinkedIn, which are essentially near-monopolies in their own market niches.
By the way, for an excellent read on Redfin, check out this Newsweek article, "Why Redfin, Zillow, and Trulia Haven't Killed Off Real Estate Brokers." The grander theme of the article is that the online real estate sites haven't radically changed the way real estate is bought and sold. While Redfin's model was more ambitious than Trulia and Zillow, the basic thrust here is that none of these companies are truly disruptive. Trulia and Zillow may help get real estate listings into a more visible and heavily trafficked place, but it seems unlikely that they will take more than a very small piece of the pie.
Unlike Google and LinkedIn, Zillow appears to be a small piece of the overall value chain, and faces significant competition even for that niche.
7. Heavy Insider Selling
It's difficult to blame officers at Zillow for selling off their shares. If most of us were in the same situation, with a good chunk of our wealth tied to one risky, early-stage business, we'd certainly do the same thing. It's always wise to diversify your wealth a bit, especially after the value of your business increases 5-fold in a few years.
At the same time, heavy insider selling is rarely a sign that a stock is attractive. By my estimates, using Yahoo Finance data, it would appear that insiders have dumped over $120 million in shares over the past year. That's a lot and reminds me of similar rounds of insider dumping at overvalued companies, such as First Solar in 2008.
I can't blame any of Zillow's officers for banking a cool million or two, which should buy them prosperity for the rest of their lives. But the extreme level of insider selling suggests to me that Zillow's officers are also skeptical about the valuation.
The Good: Revenue Growth
With all the negative arguments ironed out, it's time to look at the positive. The biggest positive is rapid revenue growth which can be seen in the chart below:
Not a lot of companies are growing revenues 77% YOY or achieving a 61% annualized growth rate over the past four years. This is one reason why Zillow probably deserves a high multiple; just maybe not 23x revenues.
Both Zillow and Trulia will continue to grow, as more real estate listings come online, and it's likely that more agents will turn to these companies in the future. More site visitors will result in higher ad revenue, and more agents buying in will increase Zillow's position within the market.
I won't iron out the complete bull case, which I think you can find countless other number of places, but certainly, I view Zillow as a high-growth company, with a good product, and a great future. It's likely a great place to work right now, as rapid growth also means more advancement opportunities. It's just that the stock is very, very expensive.
Valuing early-stage, high-growth firms is always a difficult task, but I'll take a stab at it with Zillow. Given the moderate-to-low operating leverage in the industry, coupled with moderate prospective operating margins, I'd suggest that Zillow should sell closer to 5x revenues, rather than 20x revenues.
There are still significant risks in this industry, and the otherworldly growth of the past four years will likely slow down in upcoming years. Given Zillow's lack of profit history, it pays to be a bit conservative here, but at the same time, you can't ignore the revenue growth, so somewhere around 4x - 5x sales seems reasonable.
At 5x revenues, Zillow's market cap would be $665 million and the stock price would be around $20. Its current market cap is about $3.1 billion and the stock price is $90. These are 1999-era tech valuations and even if Zillow is a great company with a great future, the stock will likely yield highly negative returns going forward.
Betting Against Zillow
While the inflated valuation might tempt one to initiate a short position or buy put options, I'd proceed with caution on that front. The stock is heavily shorted, with Yahoo Finance reporting that 46% of the outstanding shares are short. Likewise, put options are extremely expensive. To buy 2015 put options, and come out with a significant (100%+ profit), you have to bet on the stock price correcting an awful lot; not necessarily something I'd want to do with an extreme momentum stock like Zillow.
Therefore, my recommendation is to keep away on the long side, and be cautious on the short side.
I authored this article before yesterday's after-market plunge in Zillow and Trulia. It doesn't really change the basic thesis of the article, but would alter some of the multiples and figures a bit.
Zillow (as well as Trulia) are both great companies with bright futures. Both will see rapid growth in the upcoming years, as well, but paying 23x revenues for Zillow is a poor investment strategy. At such an elevated price level, the odds of making a reasonable return is very low. Even Google at the end of 2005 (which sold at 22x sales), only yielded a 6.8% annualized return over the next seven years (vs. a 4.3% yield on a 7-yr treasury), and Google had high operating leverage, a proven business model with sky-high margins, and is one of the greatest success stories of the past century.
Zillow may be a great company, but it's not Google. This is a good real estate services firm that may churn out reasonable margins sometime within the next few years. That probably makes it worth closer to $20 - $25 per share, rather than $90.