Zillow: Second Derivative Housing Play and Potential Short Sale

Aug. 9.11 | About: Zillow Group, (Z)

Internet stocks have been good performers of late. Some of the original crop of internet companies such as Amazon (NASDAQ:AMZN), Priceline (NASDAQ:PCLN) and Expedia (NASDAQ:EXPE) have not just survived but have thrived. We can appreciate, understand and endorse the business model of each of those companies and see a bright future for each. The market obviously agrees as both Amazon and Expedia shares hit all-time highs recently after each issued its respective earnings report and Priceline came very close to making a new yearly high last week after its “beat and raise” earnings report.

Following well-received IPOs by LinkedIn (NYSE:LNKD) and Pandora (NYSE:P), real estate site Zillow (NASDAQ:Z) successfully came public Wednesday July 20. The deal came at an initial offering price of $20 per share, which was above the expected range of $16-18 a share -- itself up from the original estimate of $12 per share. The offering was a small one of just 3.5 million shares, so it is easy to understand how the offering was over-subscribed. As everyone knows, the stock opened at $60 before closing the day at $35.77, up 79%.

Some of the attraction was because of pent-up demand for social media stocks. When we think “social media,” we think Facebook. While there probably is no uniformly accepted definition of a “social media” stock, to paraphrase Justice Potter Stewart, “We know it when we see it,” and Zillow is in no way a social media company. Zillow is a real estate information company that can be viewed as a derivative play on the residential real estate market. Knowing how moribund the general residential real estate market is nationally, we have a difficult time extrapolating optimistic growth rates far out into the future in a vain attempt to justify the $1 billion value currently assigned to the company. Please keep in mind that Zillow’s 2010 revenue was only approximately $30 million, thereby making the market cap over 30 times revenues (not earnings, of which there are none) on the initial day of trading.

Everything about this stock feels wrong – even its stock symbol. How did Zillow manage to score a coveted one-letter moniker? Without reminiscing too much, we remember when one-letter symbols were reserved for the great icons of American industry. We were rendered speechless when Pandora scored its one-letter symbol; now we simply don’t know what to think. Certainly this has to be a historical first in awarding a one-letter symbol to a money-losing quasi-start-up with annual revenues of only $30 million. It would be difficult to lower the bar after this decision.

At any rate, Zillow has racked up close to $80 million in losses since 2004. Some are actually calling Zillow a growth company, as year over year revenues are currently increasing at a healthy clip. We dismiss such claims by pointing to the small base and question the sustainability. We would remind all that Zillow’s revenue primarily comes from the sale of display ads to real estate agents and mortgage lenders. While we have no hard figures on overall spending in the real estate-related advertising market, it is intuitive to us simply by looking at the shrunken size of the real estate/housing section of our local Sunday newspaper that this market is not healthy.

If Zillow was one of the houses that it supplies information on, we would have to say it would be a candidate for a “short sale” as soon as the 40-day cooling off period expires and the underwriters, like lemmings, come out with their inevitable buy recommendations. Another long term negative in our mind is that, although insiders did not sell into the IPO, they control approximately 87% of the outstanding stock. This we view as a huge dark cloud overhanging the stock, as some of that 87% eventually is dribbled into the market after “lockups” expire, either through open market sales or future secondaries. After an artificial boost to the stock price from the anticipated recommendations, we would expect the stock to drift downward. We would further point out that the Zillow IPO had a rather unusual provision that could reduce the standard 180-day lockup period in half for some of the insider stock so long as the share price stays above $25 per share.

In summary, we do not think Zillow deserves the lofty valuation of a “social media” stock; rather, we look at the company merely as a second derivative play on a very sick and anemic housing market that shows little in the way of near term recovery. If and when we see housing recovering, we think the leading homebuilders will provide a more focused and leveraged play on the residential real estate market. We would look to exit any positions immediately after any uptick that might result from upcoming “mandatory” underwriters' recommendations.

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