byu economist case competition report

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Still waiting for disruption

Team Solid Ground Brigham Young University

Brock Burrows Steve Mineer

Jorge Montalva

MBA Case Competition 2014 Muddy Waters Investment Competition


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Abstract

The real estate market has been moving towards a digital platform and the online space has

become diverse and competitive. Zillow’s acquisition of Trulia is the best option both companies

have to stay relevant in the online space of real estate listings; however, due to execution risk of

the combined company’s purported synergies, coupled with extremely high short interest in both

stocks, the prospects for success of the combined company post-acquisition are low. Zillow used

its high price-to-sales ratio to lure Trulia’s board and shareholders into being acquired and

managed under the Zillow umbrella. Much of the companies’ overvaluation is based on

questionable potential market size and sequential revenue increases; however, neither company

creates much of its own content nor turns a profit. Investors should be skeptical of each

company’s assertions and should also be aware of potentially disruptive moves other companies

are making in this space. Investors should find opportunities to maximize returns with short

positions both in the long and short term.


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Introduction

Zillow’s acquisition of Trulia has caused a wide variety of reactions, from “this will change real

estate as we know it” to “this will change nothing”. The reality is that the acquisition

announcement is one more reflection of a dynamic and evolving industry coming late to the

technology party. Two things are clear: consumers are hungry for a better, simpler way of buying

a house, and multiple industry players are scrambling to be the market leader. The Zillow and

Trulia (“Z/T”) acquisition purports to be the long-awaited disruptor of this technologically

stagnant industry, but we believe this deal will only prolong Z/T’s life long enough for a true

disruptive player to emerge.

Competitive Landscape and Threats

Real estate consumers have embraced a more technologically sophisticated approach to the home

buying and selling process. Currently, 89% of homebuyers use online resources in their search

for a home. In 2013, 42% of buyers went online as their first step in the home buying process. In

2013, 45% of consumers used online resources to find the home they ultimately purchased, a

significant increase from only 8% in 20011.

As consumers migrate online, the industry must follow. Not long after Z/T’s announcement,

News Corp entered the market by acquiring Move.com, which operates Realtor.com, the third

largest player in the real estate market with 35 million unique visitors. Move.com has an

exclusive relationship with the National Association of Realtors, the largest trade organization in

the United States, with more than one million members; this has effectively aligned them with

the existing MLS structure providing them unique competitive positioning. News Corp has the


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ability to drive traffic by leveraging its other assets like the Wall Street Journal, MarketWatch

and Dow Jones Newswires, which together generate 500 million visits per month.

In addition to the News Corp acquisition, Realogy, another large player, is preparing two new

consumer-facing search portals aimed at reducing the company’s reliance on leads from Zillow,

Trulia and Realtor.com2. Realogy owns multiple real estate agencies comprising 25% of real

estate agents in the United States and in 2013, it was involved in approximately 26% of all

existing home sales3.

Small players are also trying to stake their claim to the industry. In 2013, over $429 million was

invested in 102 private technology real estate deals4. New funding was announced for multiple

crowdsourcing startups, in addition to Redfin and other web-based service providers. Even

Google entered the market with a $50 million investment in the real estate marketplace

Auction.com4 and had been rumored to be contemplating a Trulia acquisition in 20095.

Additionally, the MLS ecosystem, which is fed from agent and broker listings, is Z/T’s main

content provider. This is a source of discord with agents, since Z/T is selling leads to agents that

could not have been generated without agents putting information into the MLS.

On the surface, Zillow wants to buy Trulia because both companies have increasing brand

recognition, great consumer interfaces, complementary intellectual property, and potential

revenue synergies and cost savings. The two companies attract over 120 million unique visitors

and may be able to innovate more quickly together than separate. Zillow and Trulia are exposed

in that they do not own the listings and Zillow’s Zestimate values have been questioned by

almost every relevant player in the industry, especially agents. However, due to the

aforementioned changes to the competitive landscape, we believe this is not the power play

many think it to be; we think it is a defensive play to maintain their position by creating a


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consumer experience with which MLS companies and other industry stakeholders are forced to

interact. Thus even though we don’t believe the acquisition is an industry-changing move,

strategically, the deal makes sense to combine the two brands.

Structurally, Zillow got the better deal

Upon completion of the acquisition, every share of Trulia stock will receive .444 shares of

Zillow stock. The merger agreement places limitations on Trulia’s hiring, capital spending and

any major changes to its business. Additionally, both companies have only stated that Trulia’s

CEO’s job is the only safe one after the two companies combine. This makes great sense for

Zillow and its investors because its chief competitor is now prevented from making new strategic

moves during the approval time, but it is also clear that Zillow will be running Trulia moving

forward.

The deal also makes sense for Trulia, who is feeling the squeeze from a cash perspective. If not

for convertible notes issued in the fourth quarter of 2013, it would have no cash; Trulia, by itself

has proven to be unable to turn a profit.

If the acquisition is not realized, Zillow will be required to pay Trulia $150 million, which will

reduce Zillow’s cash balance by approximately 42% and increase Trulia’s cash balance over

70%. Since Zillow and Trulia both have benefitted by increases to their respective stock prices,

largely based on expectations of continued revenue growth for both companies coupled with the

promised $100 million in combined cost savings by 2016, a discontinuance of the agreement

would likely cause both stock prices to plummet, although Trulia could be in relatively better

position due to the extra $150M of cash.


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Economically, Zillow got the better deal

At time the merger was announced, Zillow’s stock was trading at a price-to-sales ratio of 25,

while Trulia only traded at a ratio of 12, which means that Zillow was able to negotiate for a

more fairly priced asset with an overvalued stock price; therefore, Zillow got the better deal. All

of the risk that Zillow’s stock price will drop is placed on Trulia’s shareholders until the deal is

effective. Based on the forecasted data in the S/4A, we performed a discounted cash flow

analysis and found that the J.P. Morgan estimates of the stock price has a very high upper limit

due to the “synergies” expected to be realized by Z/T. We did not include these synergies in our

analysis because no concrete examples of how the synergies would be realized have been

communicated with the public, but are hidden in JP Morgan’s assertion that it all looks good.

This should be met with skepticism. Additionally, Zillow is eliminating a competitor and is

potentially avoiding an advertising spending war for brand recognition and brand differentiation.

Trulia investors are certainly benefiting in the short term. Trulia’s shareholders enjoyed a boost

starting back in May when rumors started that the two companies would combine. When the deal

was announced, Zillow’s stock price grew such that the deal was valued as high as $3.5 billion,

which was more than double the market capitalization of Trulia, which must have appeared

lucrative to the Trulia board and shareholders. On the announcement date, the premium to be

realized by Trulia shareholders was 25.2% over the value of the Trulia stock, in addition to the

recent appreciation of the stock of 84% since May 1, 2014. The Trulia board approved the

transaction based on this valuation but as of October 29, 2014, the deal was only worth

approximately $2.3 billion, indicating a come-down in the overvaluation as well as a little more

skepticism in the market about the quality of the deal. Since the deal will be settled solely in

stock, any price decrease of Zillow stock has a material effect on the value of the deal and profits


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of the Trulia shareholders. It is unclear whether Trulia shareholders will ask to renegotiate the

conversion rate in order to preserve the initial valuation, but this is likely the only remaining

block against the deal closing.

How should investors view Z/T going forward?

Zillow and Trulia’s combined entity would become a 6.5 billion company (as of Oct 29th),

although this is a valuation that relies more on market expectations than on actual financial

performance. We believe that a significant portion of Zillow and Trulia’s respective market cap

represents future growth expectations. The following are considerations for all potential Z/T

investors:

● In 2011, Zillow estimated the size of the total addressable online real estate media market

(“TAM”) to be $6 billion7. In 2012, Zillow’s CEO Spencer Rascoff valued the TAM at

$6 billion per year, or 10% of the $60 billion agents spent on advertising8. In 2013,

Rascoff asserted TAM’s range from $6 to $10 billion9. Presently, in 2014, Mr. Rascoff

said that the market grew further to $12 billion dollars10, which is a difficult valuation for

us to accept for several reasons. First, online real estate advertising is not an industry that

is likely to double its size in three years especially without underlying data showing the

increase. Second, the $12 billion dollars reported in 2014 represents combined

advertising expenses by real estate agents, home builders and rental property managers.

80% of Zillow’s revenue comes from its agent’s marketplace. Zillow has not yet proven

to appeal to home builders and rental property managers. Moreover, that market size

assumes all 100% of offline advertising dollars can or will move online at some point,

which is inconceivable due to the interpersonal nature of the real estate business.


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Therefore, claiming a TAM of $12 billion is currently incongruent with their revenue

model.

● Zillow and Trulia source most of their content from MLS, brokerages, syndication

services, agents and homeowners. This establishes a peculiar relationship: the customers

who actually pay for advertising services on the portals are the same who enable the

creation of value by providing the listings in the first place. The nonproprietary nature of

the content Z/T uses also provides an unusual risk to investors. Z/T currently operates

under the assumption that the sources of content will not change dramatically, but some

concerning signs are starting to surface. In September 2014, one of Pennsylvania’s

biggest brokerages pulled 2,700 listings from Zillow due to accuracy problems11. At the

same time, RealTracs, a Tennessee based MLS, has severely limited information it

provides to Zillow on listings because the MLS does not feel rewarded for the access to

free content12. If Zillow doesn’t accept limited content, that opens up the door to a “this is

my content” fight that would definitely be counterproductive for the portals. There is also

a certain level of antagonism rising against Z/T perceived on social networks frequented

by real estate agents, calling for the need for agents to wake up and regain control of their

content. With 120+ million visitors per month, the portals have the upper hand, but this

could pave the way for new offerings that can address this concern more effectively and

drive agents to publish their content elsewhere.

● Big brokers such as NRT, RE / MAX, Keller Williams and Berkshire Hathaway are some

of Z/T’s biggest clients. Speculation is that higher traffic of the combined company will

lead to an increase in advertising rates. If this happens, higher revenues would follow, but

this assuming brokerages would accept price increases. This is difficult to imagine, given


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that brokerages provide a significant portion of the portal’s listings and concentrate large

amounts of agents. At the beginning of 2014, Coldwell Banker NRT agents negotiated a

91% discount on advertising in comparison to what a standard agent would pay to

advertise on Z/T13. To invest in the combined company, investors would have to accept

the feasibility of price increases to realize revenue synergies.

● A basic and more fundamental assumption to invest in the combined company is that the

FTC will actually clear the deal. The deal structure indicates that Zillow is not required to

acquire Trulia if imposed by government to change asset structure or limit ability to

“conduct” business14. To this date, the FTC has filed a second request for information,

leading to some measure of concern for anti-trust implications15. If limitations or

impositions are required by the FTC, it could put Zillow in a weak position where they

must accept the deal for strategic reasons, but having to dispose of assets that could injure

their ability to exercise their intended market leadership.

● Looking internally at the companies, a big assumption to invest is that trust in executive

leadership can be rebuilt. Excessive insider selling has created a cloud of doubt over the

stock and the long-term commitment of its leadership. Zillow and Trulia’s stock is

currently overvalued, so most investors would see value in selling at record prices;

however, investors should also expect the CEO and high-level executives to maintain

some level of long-term interest. According to data provided by Thompson Financial,

insiders have sold over 1.15 million shares over the past six months16. This creates

cognitive dissonance in the marketplace: should investors expect growth and profits in

this $12 billion industry when insiders have no future interest?


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● Z/T has publicized costs savings of $100 million by 201617. If that happens, it would

represent a cut of approximately 25% of the combined 2013 operational expenses over

the next 18 months (assuming the deal closes in June 2015). Empirical data has proven

than M&A deals generally fail to synergize any meaningful cost savings, let alone such a

material sum. Neither CEO has made clear which specific synergies may allow those

kinds of savings, which only creates more uncertainty. Investors will have to accept this

uncertainty going forward.

● In 2012, Zillow sued Trulia for patent infringement18. The portals have been rivals for

years, and industry insider Bradley Safalow mentions that the two companies “hate each

other”19. Research shows the primary factors for failure in M&A deals are characterized

by differences in management and organizational cultures, as well as mistakes in the

integration approach20. In order to invest in the combined company, investors would have

to assume a successful integration, which is unlikely given their historical relationship.

● If Z/T are going to achieve revenue synergies, they have to deliver more than traffic.

Agents measure ROI by the quality of leads provided. The current impression-based

revenue model does not emphasize successful conversion. In 2013, Zillow was providing

an average of 15 leads per agent per month at a conversion rate of 3%, representing

approximately 5.4 sales per 180 annual Zillow-generated leads21. Whether this

conversion rate provides enough agent ROI is unclear, but the company must deliver

better results if it is going to maximize the benefits of providing access to 120+ million

unique visitors.


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Trade recommendations

We believe the deal will close for two main reasons: first, after its entry, News Corp’s will be a

powerful enough to decrease the FTC’s anti-trust concerns. Second, even if limitations or

requirements are imposed on Zillow, we believe the agreement will become effective based on

how the competitive landscape is changing. The deal will underperform because some of the

assumptions noted above will likely not occur.

● First, given the evidence of past erratic guidance from Zillow’s leadership regarding

market size, the TAM will end up being far less than $12 billion dollars.

● Second, as of October 29th 2014, 42% and 27.6% of Zillow and Trulia’s float,

respectively, shorted. Stock acquirers with high short interest have been shown to

underperform following merger announcements22. Zillow’s stock is currently receiving

short interest of 42% of float, which ranks very high; therefore, we predict this Z/T

acquisition will underperform in the long run.

● Third, small stock acquirers underperform cash acquirers by up to 12% (20%) in the 12

(36) months following the merger announcement23 (Z/T would fall in this category).

● Fourth, cost reductions of $100 million will not be realized. The records in unique

visitors achieved this year were a direct effect of advertising dollars spent by both

companies. In order to grow 120+ million unique visitors per month, Z/T will quickly

realize it needs to invest more than its synergies to meet expectations forecast.

Under that scenario our current short-term and long-term trade recommendations are as follows.

In the short term, the low risk trade is initiating a short option position and taking a good rate of

return when the opportunity presents itself to cash out due to volatility. A riskier option is to

initiate a forward short position with a settlement date of six months or longer, ensuring


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sufficient cash on hand to cover bullish action. In the longterm, we believe this space will be

eventually disrupted with a player who will streamline the home-buying process and solve the

consumer’s multiple pain points.

The following are four solutions that the disruptive player must provide in order to effectively

bring disruption:

1. Integration of the entire home-buying process;

2. Superior customer platform; simple, accurate and trusted;

3. Will offer CRM and transaction management system for the selling side;

4. Will gather all stakeholders of the process: buyers, sellers, agents, lenders and title.

Conclusion

Due to the nature of the home buying and selling experience, we believe agents will remain a

vital component of the residential real estate industry. Analysts comparing Zillow to Expedia’s

total disruption of the travel agency market are misguided. We recommend keeping an eye on

potential disruptive plays by Realogy, Realtor.com, Redfin.com, and Z/T. Realogy, specifically,

is in a great position to disrupt given that it operates the complete home buying process, and

would only need to integrate the massive lead generation capabilities of a consumer-facing site.

The industry is ripe for fundamental change within the next few years, but with no clear

frontrunner we are still waiting for disruption.


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Appendix

1. “2013 Profile of Home Buyers and Sellers”, National Association of Realtors.

2. Realogy Investment Relations, Transcript: 2014 Investor Day, May 9th 2014.

3. Realogy Franchise Group, http://www.realogy.com/about/rfg.cfm.

4. “Real Estate Tech Funding Tops $429M across 102 Deals in 2013”, Mar 30, 2014, http://www.cbinsights.com/blog/real-estate-tech-venture-capital-2013. 5. “Google could buy real estate site Trulia”, Dec 19, 2009, http://www.businessinsider.com/open-house-google-has-also-been-eying-trulia-in-real-estate-search-play-2009-12 6. “Time for agents to make the rules”, Sep 17, 2014, http://www.inman.com/2014/09/17/time-for-agents-to-make-the-rules. 7. “Record revenues propel Zillow to profitability in Q2”, August 24, 2011, http://www.inman.com/2011/08/page/4/. 8. “Zillow Chief: Here’s Why We Can Be A Billion-Dollar Company”, April 26, 2012, http://www.businessinsider.com/zillow-chief-heres-why-we-can-be-a-billion-dollar-company-2012-4. 9. “An Interview With Zillow CEO Spencer Rascoff”, July 16, 2013, http://www.fool.com/investing/general/2013/07/16/an-interwiew-with-zillow-ceo-spencer-rascoff.aspx. 10. “Zillow Announces Acquisition of Trulia for $3.5 Billion in stock”, July 28, 2014, http://zillow.mediaroom.com/2014-07-28-Zillow-Announces-Acquisition-of-Trulia-for-3-5-Billion-in-Stock. 11. “Big Pennsylvania Brokerage Cuts Off Flow of Listings to Zillow”, Sep 12, 2014, http://www.inman.com/2014/09/12/big-pennsylvania-brokerage-cuts-off-flow-of-listings-to-zillow/. 12. “MLS will send only the bare bones of listing data to Zillow, Trulia and realtor.com”, Sep 16, 2014, http://www.inman.com/2014/09/16/mls-will-send-only-the-bare-bones-of-listing-data-to-zillow-trulia-and-realtor-com/. 13. Coldwell Banker Featured Agent Branding Program April 1, 2014, through March 31, 2015 – Page 42. 14. “In Deal for Real Estate Listing Trulia, Zillow Comes Out On Top”, http://dealbook.nytimes.com/2014/07/31/in-deal-for-real-estate-listing-trulia-zillow-comes-out-on-top/. 15. Zillow, Trulia Receive Second Request for Information from FTC, Sep 3, 2014, http://investors.zillow.com/releasedetail.cfm?ReleaseID=868987. 16. “Should Inverstor Follow Zillow Insiders and Cash Out?” http://www.fool.com/investing/high-growth/2014/10/22/should-investors-follow-zillow-inc-insiders-and-ca.aspx. 17. “Zillow Announces Acquisition of Trulia for $3.5 billion in Stock”, 28 Jul, 2014, http://info.trulia.com/zillow-announces-acquisition-of-trulia. 18. “Zillow sues Trulia for patent infringement, escalating bitter real estate rivalry”, Sep 13, 2012, http://www.geekwire.com/2012/bitter-rivalry-escalates-zillow-sues-trulia-patent-infringement. 19. “Why a Zillow Acquisition of Trulia Makes a Ton of Sense, and a Few Reasons Why It Doesn’t”, Jul 25, 2014, http://www.geekwire.com/2014/zillow-acquisition-trulia-makes-heck-lot-sense-reason-wouldnt. 20. “The M&A Paradox: Factors of Success and Failure in Mergers and Acquisitions”, Jan 16, 2014, http://www.ftpress.com/articles/article.aspx?p=2164982.


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21. “An Interview with Zillow’s Chief of Revenue Officer”, Jul 16, 2013, http://www.fool.com/investing/general/2013/07/16/an-interview-with-zillows-chief-revenue-officer-gr.aspx. 22. Acquirer Valuation and Acquisition Decisions: Identifying Mispricing Using Short Interest, Ben-David, Drake, Roulstone (2014). 23. Why Do Small Stock Acquirers Underperform in the Long-Term, Ben-David, Roulstone (2009).

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