On the face of it, 2013 was a great year for online real estate company, Zillow (Z). It saw stratospheric growth in users, Premier Agent subscribers and revenue and managed to broaden its lead over competitors Trulia (TRLA) and Move (MOVE).
However, looking beneath the surface, escalating costs and a more aggressive marketing strategy from Trulia point to Zillow continuing to be a compelling short in 2014.
2013 in review
Zillow ended 2013 with impressive revenue growth and gains in both unique users and Premier Agent subscribers. Revenue grew 69.1% year-over-year to $197.5 million. It reported a record 70 million unique users in January, an increase of 24 million year-over-year. Premier Agent growth was 64%, and it exited 2013 with 48,314 subscribers.
The above growth rates are certainly impressive, but further examination reveals some worrying trends that may give investors cause for concern.
Revenue growth slowing
After an impressive run, revenue growth for Zillow is now starting to slow. You can see from the graph below that revenue growth peaked in 2011 at a staggering 116.8%, which has since tapered off to 69.1% in 2013. Revenue growth for 2014 implied by the midpoint of management guidance ($291 mil) is 47.3%.
Source - Zillow
On the face of it, 47.3% top line growth is certainly nothing to sneeze at - but moving further down the income statement, things look less encouraging.
Operating leverage? What operating leverage?
It's fairly evident from Zillow's financials that top line growth has yet to translate into improved bottom line profitability. The graph below shows operating costs as a percentage of revenue for the last 5 years.
Source - Zillow
What really stands out is the significant ramp-up of sales and marketing expense beginning in 2012 and accelerating in 2013. Sales and marketing reached a staggering 55.1% of revenue in 2013, as a result of Zillow's national advertising campaign (at a cost of approximately $40 million) and Zillow's continued need to invest heavily in sales and marketing to generate incremental Premier Agent subscribers revenue.
Growth in sales and marketing is outpacing user and subscriber growth
The graph below illustrates how growth in both unique users and Premier Agent subscribers has decelerated in the last two years, while there has been a significant ramp-up in sales and marketing expense growth. Despite sales and market expense increasing by 121% in 2013 over 2012, Premier Agent subscribers and unique users increased by a much more modest 63.9% and 57.4%, respectively.
Source - Zillow
One can be forgiven for wondering whether Zillow's mammoth sales and marketing efforts are beginning to be subject to diminishing marginal returns.
Advertising expense to ramp significantly in 2014
Based on Zillow's guidance for 2014, we shouldn't expect the parabolic rise in advertising expenses to slow down any time soon. In addition to the roughly $40 million Zillow spent on advertising in 2013, it is forecasting advertising spend to increase to $65 million in 2014. If we take the midpoint of its revenue guidance, this would be an increase from approximately 20% of revenue in 2013 to 22% in 2014.
The competition isn't standing still either, with Trulia announcing during its recent Q4 conference call that it too is jumping on the national ad campaign bandwagon and is intending to spend $45 million on advertising in 2014. The obvious question is how the simultaneous escalation of advertising expenditure by Zillow and one of its major competitors will impact both firms' ROI, given they are competing for the same consumers and a finite real estate advertising spend.
Zillow's EBITDA target - further away than ever
The end result of this bloodthirsty battle for mind share is that Zillow continues to move further away from management's "near-term" target financial model, as articulated by Zillow's CFO, Chad Cohen back in March 2013 at the Investor and Analyst Day.
You can find the presentation here, with the relevant slide on page 3.
During the presentation, Chad explained that "in the near-term", management is "committed" to ramping (non-GAAP, adjusted) EBITDA margin towards 30-35% when it reaches $200-$250 million in revenue. In fact, he goes further and suggests the company can achieve EBITDA margins of 40-45% as it approaches $500 mil in revenue "given the relatively fixed nature of the investments we're making".
The company was just shy of the $200-$250 million revenue milestone in 2013, but should comfortably exceed it in FY2014 if the company meets management guidance. But rather than progressing towards its stated goal, the company is consistently moving in the opposite direction.
After achieving an EBITDA margin of 22% in 2012, EBITDA margin declined to 15.1% in 2013. Based on the midpoint of guidance for 2014, EBITDA margin will likely decline further in 2014 towards the mid-13% range. Not great - but things look even worse on a GAAP-basis.
Zillow likely to report even larger GAAP net loss for 2014
Zillow did not provide GAAP net income or EPS guidance for 2014, instead providing non-GAAP adjusted EBITDA guidance of $38-$40 million. Discussing the (arguably dubious) practice of technology companies' attempts to get investors to focus on such non-GAAP measures goes beyond the scope of this article (For those interested, I'd recommend the recent article by Professor Aswath Damodaran of Stern University on the subject). And certainly, Zillow is not alone in that respect. But it is important to make the point that Zillow's non-GAAP, adjusted EBITDA measure excludes two major expenses which are deducted to arrive at GAAP net income - stock compensation and depreciation and amortization.
Stock compensation may be a non-cash expense; but it is certainly still a real expense from the perspective of shareholders, given the resulting dilution of exercised stock options reduces earnings accrued to existing shareholders in future periods. And Zillow's stock compensation expense has grown exponentially in recent years - both in absolute terms and as a percentage of revenue.
Likewise, depreciation and amortization has increased in recent years, and management's guidance for 2014 implies it will climb significantly higher this year. It is worth noting that Zillow capitalizes a significant portion of its web development expenses, which means these costs are not captured at all in its adjusted EBITDA metric. Ignoring depreciation and amortization effectively ignores much of the significant investments in technology Zillow is having to make to generate its impressive top line growth.
The increases in both expenses as a percentage of revenue over the last 3 years is shown below, including the implied increase in 2014 based on the mid-point of management's guidance.
Source - Zillow
The net effect of these costs increasing as a percentage of revenue is a growing divergence between Zillow's reported adjusted EBITDA and GAAP net income, as shown below.
Source - Zillow
Even as adjusted EBITDA has risen, GAAP net income has declined due to ballooning stock compensation and depreciation expenses.
Management's guidance for 2014 implies this trend is set to continue. Adding back depreciation and amortization and stock compensation to EBITDA implies a GAAP net loss of around $29.5 million at the midpoint - more than double the net loss of $12.5 million in 2013.
2014 will likely be a critical year for Zillow. With such a lofty valuation, expectations are high and it is apparent that Zillow is having to spend aggressively on sales and marketing to try and meet those expectations. The result has been widening GAAP net income losses, which is set to continue this year if management's guidance is taken at face value. Trulia is facing similar challenges and is set to respond in kind, bringing into question just how effective the massive ramp-up in advertising spend will be for both companies.
At some point, Zillow will need to demonstrate that the business can continue to grow strongly AND dramatically improve operating margins. Whether that is achievable remains to be seen.