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Summary

  • Zillow's offer to acquire Trulia greatly increases the value of both companies.
  • Zillow's valuation surge takes it to the number 1 spot among select internet companies (before Twitter's earnings of course).
  • As a result, the market appears to be mispricing execution risk.

Last month, I claimed that the Priceline (NASDAQ:PCLN) deal to acquire OpenTable (NASDAQ:OPEN) helped to calibrate valuations for internet stocks. The Zillow (NASDAQ:Z) deal to acquire Trulia (NYSE:TRLA) upped the ante on valuations in a big way.

The rumor and then the actual announcement was a rare episode where both the acquirer and the acquisition target increased in price and valuation. The rumor went public Thursday, July 24th. Zillow's stock was neatly resting against its 50-day moving average (DMA) - coincidentally, so was Trulia's stock - with a $5.0B market cap. By the Friday's close, the last trading day before the deal went official, Zillow was a $6.3B company. Trulia fared even better of course. It went from a $1.5B company to a $2.1B company. When the market closed after the deal was officially announced on July 28th, the combined company had soared to a value of $8.7B from the $6.5B they were worth right before the rumors. In other words, simply by combining forces, the market "decided" that these companies would generate another $2.2B in value. Those are pretty lofty expectations for companies that earned a combined revenue of $399M in the last 12 months: around a 5.5X multiplier just for merging. (Valuation and market cap data are from Yahoo! Finance)

The trend in the 50-day moving average has been Zillow's friend…and magnet this year.

Trulia's breakout in May is validated by the Zillow deal…

Source: FreeStockCharts.com

The deal pushed Zillow to the number one spot on my valuation of internet-related companies (of course, Twitter (NYSE:TWTR) is likely to retake #1 after the market opens post-earnings). Trulia jumped to #4, pushing ahead of OpenTable and creating a new bar for valuations.

(click to enlarge)Zillow launches itself to top-rank in price-to-sales by buying a fellow high multiple company

The conference call explaining the deal was not quite as interesting as PCLN's for the OPEN deal. The most interesting moment came when an analyst from JMP Securities asked roughly the following:

"Why now? Both companies continue to grow at strong rates, taking share. So why now? Are there any markets where Trulia is stronger than Zillow and vice versa, and are there markets where this might effect pricing."

Zillow CEO Spencer Rascoff smartly answered "Why not now?" He went on to make the point that Zillow's board unanimously agreed that it would rather own 2/3 of the combined company than 100% of Zillow. Indeed, when the market closed at the end of the day, 2/3 of the combined company was worth 17% more than Zillow alone was worth before the rumors began. So on pure math, this deal is a no-brainer, particularly from Zillow's perspective and even more if the two companies can indeed reach the projected $100M in "cost avoidances" by 2016. Rascoff summed up the valuation story this way:

"If you start looking at the total price, and deal multiples, you can start, sort of, going crazy trying to think through the transaction. If you think about it as an exchange ratio, stock deal and pro forma ownership, I think that's how we approached it…"

The market went crazy anyway but in a direction beneficial to both companies.

I was fortunate enough to be long Trulia before the rumors broke but not quick enough to take off a limit order to sell at $47 when I noticed the reaction in the stock to the rumors. I had on a purely technical trade playing support at the 50DMA. Now, I am positioned the other way with a put spread on Zillow. As the market soared in response to the acquisition news, it just seemed to me that Zillow should be trading back where it was before the rumors of a deal. The deal will not close for many months out and the core benefit is projected out two years. There has to be a lot of execution risk baked into this deal going forward, risk that is being grossly mispriced. I could of course be wrong, but I think the risk/reward is very attractive here.

The next hurdles are earnings reports for both companies in the coming week. It is hard to imagine that their combined earnings news will trump the grand excitement of the deal, creating additional downward bias on their stocks. Finally, August and September tend to be the weakest months of the year for the stock market…

Be careful out there!

Source: Zillow Tells The Market Not To Go Crazy Thinking About Valuations On Trulia Deal

Additional disclosure: Short Zillow via a put spread.