Last Friday, Citron Research released a bearish report on Zillow (Z) leading to over 6% correction in the company's share price. I won't go into the full details of the report but the key metric Citron is questioning is extraordinary growth in sales & marketing expense in Q2 as compared to topline growth. Citron further goes on to say that unlike LinkedIn (LNKD), Zillow's sales and marketing expense is unpredictable and "something else entirely". (see below)
Source: Citron Research's report
On the face of it, i.e., if you don't dig deeper into the numbers, Citron's case makes sense. However, after looking at the company's filings it appears that Citron is selectively disclosing information to make Zillow look like more than just a valuation short.
The company reported 2Q13 revenue of $46.92 million versus $27.76 million in 2Q12. Its sales and marketing expense in 2Q13 was $32.92 million versus $12.15 million in 2Q12. So, the company's revenue increased 69% while sales and marketing expense soared 178%.
However, before jumping to conclusions let us first understand what caused this disproportionate increase in sales and marketing expenses for Zillow in 2Q13. Out of $32.92 million, $7.1 million was a one time expense related to the accelerated vesting of 218,071 unvested restricted stock units by a former employee.
For the three months ended June 30, 2013, share-based compensation expense includes the impact of $7.1 million of expense related to the accelerated vesting of 218,071 unvested restricted stock units. In April 2013, pursuant to the terms of a Restricted Stock Unit Award Notice and Restricted Stock Unit Award Agreement between Zillow and a former employee, all unvested restricted stock units held by such employee became vested, such that the former employee received one share of Zillow's Class A common stock for each outstanding restricted stock unit.
Source: Zillow's 2Q13 10Q
In addition, another $8.4 million was primarily related to advertising spend which the company's management has clearly stated that they would double in their 1Q13 call. Unlike direct sales expense, advertising spend to create brand awareness may take sometime to play out and show in the topline numbers. Citron somehow tried to present that this $8.4 million is proportionally related to cost of acquisition of revenues in the second quarter. In reality this expense is related to the company's effort to acquire shoppers across online and offline channels which will help it in the long term.
Sans these two items Zillow would have reported only 43% increase in its sales and marketing expense against 69% increase in topline showing the operating leverage in the model. As per management guidance, advertisement expenses which began ramping up in second quarter of this year are unlikely to see any significant sequential increase from here for the rest of this fiscal year. And although management has not explicitly commented, I don't see any significant increase in advertisement spend going into FY14.
According to Citron, the pivotal question every investor needs to ask is:
And if its best days are still in front of it, patient investors could reap even more rewards.
Given the fact that extraordinary items significantly affected Zillow's second quarter results and the company is likely to face easier sales and marketing comparisons staring in 2Q14, I believe the best days are still ahead of it in terms of business fundamentals. The stock is unlikely to crash until the broader SaaS and Web2.0 bubble finally bursts.