Zillow: Valuation Matters

| About: Zillow Group, (Z)

I first started covering the lofty valuations in certain subsectors of technology on May 2, where I described it as a localized bubble. In a follow-up article on July 1, I reexamined the companies on the original list and discussed their relatively poor performance along with the arrival of new IPOs that would have made the original list. With each new tech IPO, though, it seems that investors are behaving more and more irrationally. While I cannot say for certain that we are at the peak of the bubble (1999-ish) instead of the beginning (1996-97-ish), I believe the long term outlook for shares in aggregate is highly negative even though they represent ownership interests in compelling (mostly) well-run businesses. Why? Because valuation matters.

Let's look at Zillow (NASDAQ:Z) in more detail. With $30.5M of 2010 revenue and a net loss of $6.7M, the company is being valued in excess of $1B. That represents a multiple of more than 33x trailing revenue for a relatively small, unprofitable, cyclical, advertising-supported business. While we may be closer to the bottom of the cycle than the top, in terms of volume of real estate transactions, one still must wonder how long it will take (if ever) for Zillow to grow into its massive large-cap valuation. ZipRealty (NASDAQ:ZIPR), another publicly traded Internet company with exposure to the real estate market, is currently trading at an EV/revenue ratio of ~0.33x. Yes, that unprofitable company is valued at one-third of trailing revenue even though it has ~4x as much revenue as Zillow and more than 1.5x as much gross margin as Zillow has revenue. Nevertheless, ZipRealty has a market cap of only ~$64M while Zillow is valued at over $1B. According to Quantcast, ZipRealty has ~1/4 the traffic as Zillow, yet its market cap is ~1/15 of Zillow and its enterprise value is even lower relative to the recent IPO.

The vast difference in valuation between a recent tech IPO and similar publicly traded competitors is not limited to Zillow. Pandora's (NYSE:P) nearly $3B market cap for an unprofitable ~$200M revenue run-rate business (based on Q1 2011 numbers) whose margins will always be challenged by music royalties is almost as shocking as Zillow's valuation. But if you look at the multiples of revenue commanded by Atrinsic (NASDAQ:ATRN), the parent company of the Kazaa music streaming service (EV/revenue of 0.5x) or RealNetworks (NASDAQ:RNWK), a part owner (with MTV Networks) of the parent company of the Rhapsody music streaming service (EV/revenue of 0.42x on over $401M of revenue), you have to wonder what Pandora investors are thinking.

It would seem that the dumb money is chasing novelty as it relates to their investments in the same way as they chase novelty at retail. In some respects, paying a relative price of 10+x times as much for the latest tech IPO instead of a close competitor is arguably no different than spending 10x as much on this year's designer handbag instead of last year's closeout. But while fashion-conscious shoppers will have temporary bragging rights by owning a stylish new accessory, it is the value-conscious investor who will have bragging rights by having superior investment returns.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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