This article is an analysis of Zillow's (Z) current business and future prospects as demonstrated by their fourth quarter performance. After review, we have come to the following conclusions:
- Zillow had an excellent fourth quarter of 2011, and their business has strengthened in early 2012;
- Zillow's competitive outlook is unchanged: while certainly not a monopoly, Zillow has dominant market and mind share within the on-line real estate information sector;
- While Zillow's stock market valuation is very high, we believe it is justified by a) the company's brilliant execution; and b) strategic opportunities. Our analysis predicts that Zillow's earnings and cash flow growth in the next three years will more than offset the normal decay in the company's stock valuation;
- We are upgrading our rating on Zillow shares from Hold/Neutral to Buy/Long.
After the market close on Wednesday, February 15, Zillow reported its fiscal 2011 fourth quarter (December) results. The company reported GAAP earnings per share of $0.03, which was $0.03 ahead of the breakeven consensus (8 analysts) estimate. Revenue of $19.9m (up 108% year-over-year) was modestly ahead of the $18.8m consensus.
- Marketplace Revenue (69% of total revs) increased 169% to $13.7 million from $5.1 million in the fourth quarter of 2010.
- Display Revenue (31% of total revs) increased 38% to $6.1 million from $4.5 million in the fourth quarter of 2010.
- Average monthly unique users grew 86% to 23.5 million in the fourth quarter of 2011 compared to 12.7 million average monthly unique users for the same period in 2010.
- In addition, January 2012 was a record traffic month with 31.7 million unique users, representing 102% growth over January 2011.
- According to compete.com, Zillow's January 2012 unique visitor count was 9.67m, up 72% y/y; Realtor.com was 8.89m, up 35% y/y; Trulia was 8.03m, up 66% y/y; Homes.com was 4.86m, up 64% y/y; Redfin was 1.82m, up 107% y/y
- In December 2011, homes were viewed on Zillow Mobile nearly 100 million times, or 36 homes per second.
- In addition, January 2012 was another record month for mobile usage, with 53 homes viewed per second on Zillow Mobile.
- Premier Agent subscribers totaled 15,799 at December 31, 2011, up 95% from 8,102 at the end of 2010 and up from 14,876 at the end of September, 2011. Premier Agent revenue is reported as part of Marketplace Revenue.
For FQ1 (March): Zillow management offered the following guidance in its published earnings announcement and conference call:
- Revenue is expected to be in a range of $20.5m - $21.5m, compared with the $20.7m consensus estimate. The mid-point of this revenue range would represent year-over-year growth of 87%.
- EBITDA is expected to be in a range of $25m - $27m. Adjusted EBITDA is expected to be in a range of $3.0m - $3.5m; the mid-point of the range would represent growth of 200%, year-over-year. Additionally, the mid-point would represent EBITDA margin of 15%, up notably from the 9% margin achieved in Q1 2011.
- The fully-diluted share count for Q4 2012 is expected to be roughly 33 million; this will be up from 30.6 million in Q4 2011.
What It Means:
Zillow's fourth quarter was an impressive demonstration of market power.
The fact that Marketplace revenue (up 169% y/y) grew faster than Premier Agent subscribers (up 95% y/y) means that Zillow is not only signing up more agents, it's getting a larger share of marketing spend from each agent, because agents are renewing at higher subscription rates.
Moreover, Zillow has waiting lists of brokers in some markets, and when some current broker customers decide to end their subscription relationship with Zillow, they are easily and quickly replaced by those on the waiting list, and at higher price points. Some brokers at the end of their subscriptions are choosing to maintain the same subscription rate, but in doing so get less exposure on Zillow's site.
Postives/Upward changes to expectations:
Google just exited the Mortgage Marketplace business (a $10b annual market), improving Zillow's competitive position.
Zillow will shortly be rolling out a customer relationship management, or CRM, platform for agents. The new product will help agents better manage and organize the contacts they receive from Zillow via a mobile device or desktop. The app is designed to save the contacts agents receive through Zillow, including their recent search criteria, and allows agent to make individual notes and star high-priority contacts.
Given the importance of an agent's client list, success in this type of CRM effort could be very powerful in furthering Zillow's market influence. This effort is just beginning so the only financial impact is development expense, but we'll watch this carefully throughout 2012.
Negatives/Downward changes to expectations:
Display ad growth decelerated from 57% in the third quarter of 2011 to 38% in the fourth quarter. Zillow management described the lower growth as being above expectations, but this number has been volatile for several quarters.
Some pushback from out-of-contract agent subscribers being asked to re-subscribe at higher price points just to maintain the same level of promotional support. This is certainly logical, and hasn't yet manifested in widespread (or even moderate) subscriber defections. But we'll watch this trend very closely: Zillow's revenue growth is ever-more tied to subscribers, as opposed to advertising.
There has been an acceleration in insider selling at Zillow, which is not surprising as we are now firmly past the 180 day traditional lock-up period since Zillow's July 20, 2011 IPO. Thus far in February alone, there have been over 1 million shares sold by Zillow insiders. The majority has come from Chairman Richard Barton and Vice-Chairman Lloyd Frink. But others, including CEO Spencer Rascoff, are now selling as well. This selling is unsurprising and with 2/3rd of the shares outstanding still in the hands of insiders and Zillow's venture capital investors, we expect it to continue.
Valuation (Valuation Decay, DCF and Comparative Analyses):
Valuation Decay Analysis:
We're introducing a new valuation methodology that we feel is particularly suitable for young, high-growth, high P/E companies like Zillow. We call this the Crabtree Valuation Decay model, which we feel reflects the inevitable deceleration in both company growth and market valuation.
Many high-growth technology companies have gone public in the past thirty years, from Microsoft (MSFT) and Apple (AAPL) to Amazon (AMZN) and eBay (EBAY) to Google (GOOG) and VMware (VMW). It's our experience that even for companies that have maintained high levels of revenue and profit growth, price:earnings ratios decline over time. A quick review of the aforementioned firms shows that virtually all of them have valuations that have "decayed" to nearly market multiples (the forward P/E on the S&P 500 is estimated by Birinyi Associates at 13.1)
Most Recent Qtr Rev. Gro.
As you can see from the table, there are still companies with unusually high valuations like Amazon, as well as Salesforce.com (forward P/E of 88, 36% revenue growth). But there are also no shortage of ones like Priceline.com (P/E of 20, 45% growth). In fact, the calculated median of forward P/E ratios among all technology stocks in our database is only 14.5; the most recent quarterly revenue growth median is 8.0%.
So with old age and decelerating growth being inevitable, lower valuations are as well. Therefore, let's analyze Zillow through this prism:
Earnings per Share
The takeaway from this table is to note that (using our assumptions), early in the process the high earnings growth rate outweighs the impact of the decaying valuation multiple, leading to the estimated share price reaching $70.75 in three years. Thereafter, the earnings growth isn't large enough to overcome the still-decaying multiple, leading to a share price decline.
Of course, all of these items are estimates, except for the current share price and current earnings multiple. If earnings growth doesn't decelerate as fast as estimated, the future share price will be higher. If the multiple decays faster, the future share price will be lower. And so forth.
But because we feel our assumptions are reasonable, and based upon real-world averages, we're comfortable with the conclusion they yield: Zillow stock is very likely going to increase faster than the market in the next three years.
Discounted Cash Flow (DCF) Analysis:
In addition to our Valuation Decay model of Zillow, we maintain a DCF model for the company. We have updated the parameters with the most recent Q4 data to arrive at our DCF value:
· Term: 5 years;
· Initial Cash Flow: $9.804 million (this represents the estimated annual free cash flow for Zillow's just-completed fiscal year);
· Initial Cash Flow Growth Rate: 80%, decelerating to a…
· Long Term Cash Flow Growth Rate: 6%;
· Discount Rate: 8.95% (derived using CAPM: Risk Free Rate = 3.10% from the 30-year Treasury Bond; 4.4% equity risk premium from Ibbotson; and an estimated Beta of 1.30);
· Current Share Count: 30.592 million (up from about 24m shares two months ago, and estimated by management to be about 33m by the end of 2012).
Using these inputs, our calculated DCF value per Zillow share is $60.30, almost exactly double the current $30.00 share price. Note that the free cash flow growth rates for years 2-5 in our DCF model are the same growth rates for earnings in our Valuation Decay model, just for consistency. Note also that the five-year DCF value of $60.30 is almost identical to the $60.40 value after five year in the Valuation Decay model - this is a mathematical co-incidence and they're not comparable anyway: the DCF is a "here-and-now" value; the Valuation Decay number represents the estimated value in five years.
We've written before that the DCF model isn't the best one to use for a fast-growing, young company such as Zillow. But we include it anyway because it utilizes cash flow rather than earnings; the former tends to be steadier and harder for a company's accountants to manipulate.
The following table compares Zillow and six other software-as-a-service companies:
Op CF Margins
MRQ Rev Growth
Float: Shares Out
LTM=Last 12 months, CF=Cash Flow, MRQ=Most Recent Qtr.
The primary conclusions we draw from this table are:
· Zillow and LinkedIn have much in common: two recently public companies, with triple-digit growth rates, very high P/E valuations and relatively low floats. Zillow, however, lacks LinkedIn's "Facebook Problem;" i.e., a major, potentially overwhelming competitive threat.
· Ancestry.com's forward P/E reflects its new status as a slower growing company. Profitable, yes. But our experience is that premium valuations come from growth, not profits. How else to explain Amazon's hypoxic valuation?
What You Should Do About It (Buy, Sell or Hold?):
We are changing our rating on shares of Zillow from Hold/Neutral to Buy/Long. Zillow is coming off a quarter in which it executed flawlessly, generated cash, and increased its market share. We feel that the company is well on its way to becoming a natural monopoly in the on-line real estate information sector.
Until recently, we felt that despite Zillow's consistently excellent performance as an operating company, its stock valuation was excessively high. Moreover, shares "un-locking" after its July 2011 IPO would create a supply-demand imbalance, depressing the share price. However, the market seems to be absorbing additional supply. And the valuation no longer seems excessive, when placed in the context of future high earnings- and cash flow-growth rates, the latter driven by proven pricing power in its Premium Agent program.
We conservatively estimate that 250,000 real estate agents in the U.S. are potential subscribers to Zillow's Premier Agent program; as of early 2012, the company had just under 16,000 subscribers, or 6.4% of the total. So the market opportunity remains quite large, the business model is proven, and management is successfully handling the responsibilities of being a public company. It's time to invest.
Please see our complete research report on Zillow, published on Seeking Alpha in October 2011.
Additional disclosure: I am long ARBA in the Separately Managed Account product for which I am the portfolio manager and in which I am an investor.