I'm a firm believer in dividend stocks, both high-yielding income stocks and dividend growth stocks. However, as part of a diversified portfolio I am open to owning growth stocks who have the potential for outsized long-term returns. While researching through some stocks recently I came across Zillow (NASDAQ:Z) and became intrigued at what appears to be one of the most promising growth stories of the next decade or two. However, the more I researched and modeled the company's potential, the more I became convinced that regardless of its phenomenal growth prospects, at its current price Zillow won't make a good long-term investment. As I'll soon show, this verdict remains true no matter how long the time horizon.
Zillow is a Seattle based company that operates a website and suite of software solutions designed to bring home buyers and real estate agents together. Initially, the company's claim to fame was the "Zestimate" which was supposed to use existing home sales data to give home owners an estimate of the value of their homes. The idea was to build a database of users, improve the company's "Zestimates" and grow a loyal following. The traffic from this strategy would then be used to sell advertising and convince real estate agents to sign up for a premium subscription to the site, as a way for agents to network with potential leads. This secondary strategy was designed to work like LinkedIn (NYSE:LNKD), acting as a market connecting real estate agents to potential buyers and sellers of homes. The network effects of having the largest database of potential customers and agents would create a powerful moat around the company's business model similar to Ebay's (NASDAQ:EBAY). Today Ebay has a massive competitive advantage in its marketplace business because they are the largest market. Sellers and Buyers want to post on Ebay because it's where the most people are.
Zillow's business model called for creating something similar in real estate, beginning with homes but later branching out. Today the company offers, in addition to its original service:
"Zillow Mortgage Marketplace, where borrowers connect with lenders to find loans and get mortgage rates; Zillow Rentals, a marketplace and suite of tools for rental professionals. The company also offers information products and services that enable consumers to make decisions about home value (such as home improvement projects) and rental price estimates."
So how well is the company executing on its growth plans?
- For 2013 Total Revenue increased 69% to a record $197.5 million from $116.9 million in 2012.
- Marketplace Revenue increased 78% to a record $154.2 million from $86.7 million in 2012.
- Real Estate Revenue grew 74% to $132.4 million from $75.9 million in 2012.
- Mortgages Revenue grew 103% to $21.8 million from $10.8 million in 2012.
- Display Revenue increased 44% to $43.3 million from $30.2 million in 2012.
-Premier Agent growth of 64%, to 48,314
-Record 70 million users in January, representing 52% growth since 2012.
In addition to these impressive growth numbers, comScore reported that Zillow had more than double the combined web traffic of its two largest competitors, Trulia (TRLA) and Move.Inc (NASDAQ:MOVE).
The company continues to innovate with the January introduction of the Postlets App on IOS. This app allows landlords, property managers and real estate agents to post ads for their rentals on the top 20 real estate web and social networking sites.
Looking forward into 2014 management is planning on increasing its advertising budget from $40 million to $65 million in an effort to expand brand awareness and offset Trulia's $45 million advertising spending.
Thus far the company has been able to execute well on its growth plan resulting in fantastic growth in revenues and the share price.
In the last 3 years sales at Zillow are up 86.4% CAGR while the share price has appreciated at 40.6% CAGR over the same time. Meanwhile analysts continue to be bullish on the company's prospects. Wall Street is anticipating 42% sales growth in 2014 and 36% in 2015. Earnings are expected to increase a breathtaking 1050% from $.06/share to $.69 in 2015 and then continue to grow at 42% annually over the next 5 years. If the optimistic predictions of analysts is all that Zillow had going for it then it would not be much of a potential investment. However, over the last 4 quarters the company has managed to crush analyst expectations by an average of 113% each time.
Given the fact that there are 2.1 million real estate agents in the U.S. and Zillow has signed up just 48,000 of them as premier subscribers, the growth potential for the company becomes obvious (it has just 2.3% market share in premium subscribers).
So Zillow is a strong buy correct? After all, the growth prospects are there, the market size is enormous and its market share is tiny but growing fast. This indicates a long runway for growth, potentially for several decades. However, I believe that Zillow makes a poor long-term investment because of one major factor, price.
|Year||EPS||5 year projected PE Ratio||5 year price target||Fair Value||Discount||Projected 5 year returns (compound annual growth rate)|
|2020||3.1941||10 year projected PE||10 year price target||Fair Value||Discount||Projected 10 year returns|
|2025||10.105110288||15 year projected PE||15 year price target||Fair Value||Discount||Projected 15 year returns|
|2029||20.0808751643136||20 year projected PE||20 year price target||Fair Value||Discount||Projected 20 year returns|
|2034||38.6337337846397||25 year projected PE||25 year price target||Fair Value||Discount||Projected 25 year returns|
|25 year CAGR||1.31514708295904|
The above spreadsheet is an attempt to model Zillow's future earnings growth over the next 25 years and assign a present day fair value to the shares. The goal is to determine a reasonable estimate for the rate of return investors can expect at today's price.
Beginning in 2014 and using the projected $.69 in EPS in 2015 I model 40% earnings growth over the next 3 years. After that, I anticipate growth to slow to a 30% CAGR for 5 more years. The 5 year periods after that see growth slow to 20%, 15% and finally 10% respectively. I attempted to assign a variety of earnings multiples ranging from pessimistic to optimistic during each 5 year period in order to determine a projected price in 2018, 2023, 2028, 2033 and 2038. I used a 9% discount rate (between 1871-2013 the stock market returned a 9% CAGR) to determine the fair value of shares today. I then compared the price today to the fair price to determine to what extent shares are trading at a premium or discount. Finally I calculate the anticipated return investors can expect over a 5, 10, 15, 20 and 25 year period. I compare this anticipated total return to those that can be found from high yielding income and dividend growth stocks to see if Zillow's potential returns make up for the increased risks associated with the company's heady valuation.
The results are sobering. Over the next 25 years I model a 31.5% CAGR in EPS which is a staggering growth rate for any company. Yet, the compound annual growth rate of the stock is expected to be just 9.45%. This barely beats the general market's long-term performance (if dividends are reinvested, the stock market's 1871-2013 CAGR is 11.1%). If market dividends are included than Zillow is expected to underperform the market's historical returns.
Over shorter periods of time investors can expect to do slightly better with the 10 year return averaging 18.65% CAGR. This is about double the market's traditional growth rate. However, when I compare this projected return to boring but steady dividend payers such as Brookfield Infrastructure Partners (NYSE:BIP), Main Street Capital (NYSE:MAIN), or Prospect Capital (NASDAQ:PSEC), I find expected returns that match or easily surpass that of Zillow. This is because high dividend stocks such as those I mentioned typically give a total return of yield+CAGR of dividends. Brookfield and Main Street have long-term dividend CAGRs of 8-9% while Prospect has just 1% but it has a 12% yield. The yield on Brookfield is 5.1% and on Main Street 7.2-7.3% when semiannual special dividends are accounted for. This gives an expected total return for these dividend stocks of 14-15% CAGR for Brookfield, 16% for Main Street and 13% for Prospect Capital. However, when you take into account dividend reinvestment (including monthly compounding for Prospect and Main Street), you get long-term total returns of about 22% for Brookfield, 24% for Main Street and 27% for Prospect Capital. These 3 companies seem to offer better future returns than Zillow and would likely do so with less volatility, less risk and pay out great dividends along the way.
Given that non-dividend paying growth stocks are supposed to compensate for their higher volatility and risk (and lack of income) Zillow, as a long-term risk adjusted investment, just does not make sense at its current price. This is not to say that the stock could not become a great long-term candidate in the future. If Zillow were to drop just 11.3% to $74.11/share then the expected 5 year total return increases to 18-48% CAGR with an average of 36%. This shows the importance of the valuation even for a great growth story. At the wrong price the greatest company in the world becomes the worst investment.
This is not to say, however, that Zillow at today's price is not a great short-term trading opportunity. With 51% of shares held short and a short ratio of 4.8 days, Zillow is the 4th highest shorted stock in America. It is a powder keg waiting to blow up in the bears faces. With the company's history of annihilating analysts expectations, a blowout quarter could send the stock up 10-20% and initiate the mother of all short squeezes. To give an example of how big the potential short term pop could be, Tesla's (NASDAQ:TSLA) historic run came off the back of a 40% short interest. Zillow's is 25% higher and the short ratio indicates that there are so few shares remaining to be traded daily, (because of high % institutional shareholders and the insanely high short interest), that it would take an entire trading week for shorts to cover. This means that Zillow presents one of the greatest potential short-term trading opportunities I have ever seen. However, it is one of the worst long-term investment thesis you're likely to find, at least at the current price.
The short-term technical indicators are neutral for Zillow. There is incredible support at $83.3 with mild resistance above at $85.3. The most recent candlestick pattern is a very bearish Gravestone Doji. However, it seems that support is holding solid.
This technical analysis seems to indicate a very good trade for those who wish to buy Zillow and ride a future short squeeze to fast profits. The stock is likely to not drop below the incredible level 15 support it is currently sitting on. Meanwhile the company's track record makes another blowout quarter likely. Of course short term speculation is not the same as investing and comes with a great deal of risk. Should the company miss expectations or the market experience a strong correction the stock might drop hard and fast.
Zillow is a wonderfully innovative and disruptive company. Its amazing growth story is likely to continue for many years to come and at the right price, it would make an amazing long-term investment. However, at the current price the stock simply cannot offer long-term investors sufficient risk adjusted returns to warrant an investment at this time. It can, however, offer short-term traders a great opportunity to cash in on a potential short squeeze, which is likely to occur within the next few quarters.
For existing shareholders, I would rate Zillow a hold because of the power of its growth potential. For new investors, I would recommend waiting for a better price such as $74-$75. For short-term traders interested in riding a short squeeze, Zillow is a definite "buy now". This is assuming you are willing to take the risk of a large loss should future growth expectations not be met.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.