2014

Ryerson University

Taking Advantage of Market Inefficiencies

Team Ryerson

University:

David Bender

Angela Holzer

Ilia Maor

Investment Competition Report for Muddy Waters

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Contents

Introduction ..................................................................................................................................... 2

Zillow and Trulia in the Context of the Online Real Estate Listing Industry ................................. 2

Growth ......................................................................................................................................... 2

Competitive and Fragmented Industry ........................................................................................ 3

High Valuations........................................................................................................................... 3

Wave of M&A Activity............................................................................................................... 4

The Acquisition Deal ...................................................................................................................... 4

As framed by the companies involved ........................................................................................ 4

Underlying considerations about M&As..................................................................................... 5

Does the structure of the deal make sense for each company? ....................................................... 6

Which company is getting the better deal and why? ...................................................................... 7

Discounted Cash Flows Model ................................................................................................... 8

Comparables Approach ............................................................................................................... 8

Rational growth projections ...................................................................................................... 10

A Schwartz Moon Model .......................................................................................................... 11

What if the deal fails to close? ...................................................................................................... 14

Assumptions required to invest in the combined company .......................................................... 14

Trading Strategy............................................................................................................................ 14

Appendices .................................................................................................................................... 17

Appendix 1 - Acquisition Patterns by the Top 3 Competitors in the Online Real Estate Listing

Market ....................................................................................................................................... 17

Appendix 2 - Perceived competitiveness .................................................................................. 18

Appendix 3 – Additional Acquisition Cost per New User Trend ............................................. 19

References ..................................................................................................................................... 20

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Figure 1 – U.S Real Estate Advertising Distribution

Source: 2013 Real Estate Advertising Outlook from

Borrell Associates, Inc.

Introduction

On July 28, 2014, Zillow announced the proposed acquisition of its closest rival, Trulia,

for $3.5 billion in an all-stock deal. The significant premium, timing, and structure of the

acquisition transaction in this deal raises several questions for investors. An analysis of the

industry, firms, the deal, as well as pertinent studies of similar deals is presented below to inform

current and potential investors.

Zillow and Trulia in the Context of the Online Real Estate Listing Industry

In the last several years, the U.S. online real estate listing Industry has been characterized

by growth, strong competition, a fragmented landscape, high valuations and a wave of mergers

and acquisitions. Market share, in terms of web traffic (KPI), is dominated by Zillow, Trulia, and

Move, Inc. in this order.

Growth

Overall, growth in the Internet industry

has been supported both by increased Internet

speed and adoption as well as the digitization of

many traditional industries. In the case of real

estate, online companies have been attracting a

growing number of users by providing online

access to listings, and are competing for a

greater portion of the overall $27 billion real

estate advertising market. Companies are showing

high growth in both revenue and reach as shown

in Table 1, and 2.

$-

$5,000,000,000.00

$10,000,000,000.00

$15,000,000,000.00

$20,000,000,000.00

$25,000,000,000.00

$30,000,000,000.00

U.S. real estate total advertising spending

U.S. real estate online advertising spending

Zillow and Trulia's combined revenues

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Table 1 - Average Unique Monthly Visitors of the Leading Online Real Estate Firms

Zillow Trulia Move

2010 11,194,917 7,935,000 9,000,000

2011 21,452,250 14,776,000 11,500,000

2012 33,975,917 23,145,000 10,600,000

2013 54,111,167 38,809,000 17,400,000

2014 79,251,556 51,633,000 21,000,000

CAGR

63%

59%

24%

Table 2 - Revenue of the Leading Online Real Estate Firms

Zillow Trulia Move

2010 $ 30,467,000 $ 19,785,000 $ 197,503,000

2011 $ 66,053,000 $ 38,518,000 $ 191,724,000

2012 $ 116,850,000 $ 68,085,000 $ 199,233,000

2013 $ 197,545,000 $ 143,728,000 $ 227,033,000

CAGR 86% 94% 5%

Sustaining the growth in ad impressions is crucial in order to retain and attract advertisers.

Indeed when comparing these competitors, the faster growing firms, in terms of reach, also

present faster revenue growth.

Competitive and Fragmented Industry

As the advertising distribution in Figure 1 demonstrates, there is huge revenue potential,

particularly because this is an untapped market. This potential combined with the low entry

barriers make the online real estate market attractive to new entrants. As a consequence,

numerous companies, such as Redfin, and LoopNet, are competing in this space, as well.

High Valuations

The earning potential and growth is also attractive to investors as reflected in the

market’s valuations of the online real estate companies. Indeed, when comparing the two leading

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firms with similar but non real estate Internet companies such as Carbonite, Monster Worldwide,

and Shutterfly, Zillow and Trulia, although not currently profitable, are valued favourably along

relative metrics (See Table 3).

Table 3 – Market Cap, Revenue CAGR, and EBITDA of Internet Companies

Market Cap. Revenue CAGR

(2010-2013) EBITDA

Carbonite 296.29M 41% 7.35M

Monster Worldwide 340.19M -2.6% 86.16M

Shutterfly 1.62B 36% 73.44M

Trulia 1.78B 94% -23.94M

Zillow 4.45B 86% -4.99M

Wave of M&A Activity

Consolidation appears to be the dominant strategy for the leaders in the space. Zillow has

either acquired or bid on nine companies since 2011. During the same period, Move bought six

companies and Trulia one. (See appendix A for a list of M&A)

The Acquisition Deal

As framed by the companies involved

The communication of this deal to the public has been positive on many fronts. Zillow

announced that the combined company would keep the brands separate and that combining their

technical resources would allow significant opportunities for faster innovation, better data for

customers and agents, and a broader listing distribution for agents. The combined company could

scale more effectively by offering agents more options and a larger database. The two companies

also present limited consumer overlap - over 65% of Zillow’s visitors are not using Trulia and

50% of Trulia’s unique monthly visitors are not Zillow users. These factors combined with the

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similarities between the two companies are projected by the company to produce $100 million a

year in cost saving synergies by 2016.

Underlying considerations about M&As

Studies have shown that about 50% of mergers and acquisitions are unsuccessful over time

(Perry & Herd, 2004). When explaining M&A failures, unrealistic expectations and

overconfidence are common factors (Kummer & Steger, 2008). To go even further, research has

demonstrated that when synergies are expected due to relatedness of the merging firms, the

actual synergies are not effective in increasing performance as they are mostly negligible, or are

outweighed by transition costs, loss of productivity, and inability to realize intended benefits

(Homberg, Rost & Osterloh, 2009).

When applying these considerations to the Zillow/Trulia acquisition, the yearly $100M in

synergies should be re-assessed and most likely expected to be overestimated. For example, the

cost of new user acquisition is rising for both companies as web traffic increases (Appendix 3).

As such, the ability to maintain the estimated synergies may be further overstated in the long-

run.

Further, research about M&As also demonstrated that both the acquirer and target firms are

usually overvalued by the market in an all-stock acquisition situation (Shleifer & Vishny, 2003).

When two firms are overvalued and aware of this misevaluation, it is rational for the acquiring

firm, more highly overvalued, to take advantage of its high stock price to buy valuable resources,

such as a competitor. In addition to this gain, the bidder is also mitigating its long run risk of

potential upcoming loss (e.g. through a market correction) as this loss will be distributed on a

broader basis between the two companies. From the target firm’s perspective, accepting a deal

with an advantageous premium allows shareholders of the company to cash-out with a higher

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return in the short-run. In addition, the trends for all-stock M&As show that returns for the

combined company are negative in the long run, although less negative than without the

acquisition (Shleifer & Vishny, 2003). The main assumptions driving this analysis are that:

The market is over-valuing both the firms and the potential combined entity;

Managers of the merging companies are aware of this market inefficiency and are acting

rationally by taking advantage of it for their specific purposes

Does the structure of the deal make sense for each company?

Assuming that Zillow and Trulia are overvalued, that Zillow is more overvalued than

Trulia, and that the managers of each company are aware of this situation while the market is

not, the all-stock structure of the acquisition is rational and beneficial for both firms. Zillow

benefits by acquiring a company with overvalued stock that will consolidate its business and that

it could not otherwise afford due to unavailable cash. In the long run, knowing that it is likely

that the market will eventually correct itself resulting in a lower stock price, Zillow mitigates

some of this loss for its shareholders by sharing the risk with a broader base.

From Trulia’s perceptive, also knowing that the company is overvalued, taking a short-

term approach by accepting a high premium and allowing its investors to cash out at a higher

return after the acquisition is the rational decision when compared to keeping an overvalued

stock. It appears that the structure allows each company to benefit from the deal and is rational

for both parties. If we understand the deal by working backwards, it becomes clear that Trulia’s

management has a strategy with a shorter time horizon than Zillow’s management. This provides

clarity as to why both sides would agree to a deal that will potentially see the value of both

companies fall.

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Which company is getting the better deal and why?

Each company benefits from this acquisition. However, Zillow will benefit more both in

the short and long-term. Although further decline of the stock price is likely to happen, such a

result is built into their reasoning for the acquisition. If the combined company does achieve the

desired synergies, they will see the value of their holdings increase. Conversely, if it does not,

then their holdings will fall- as they expect. However, the acquisition will allow them to spread

their “surplus” (which would be at risk without the acquisition) onto another company to

mitigate this “slide”. If this scenario becomes reality, Zillow will be winning big and Trulia’s

shareholders will have missed-out by leaving the market early. With this “binary options”

approach to evaluating the deal, it can be seen that Zillow has the higher upside than Trulia,

without assuming a substantially higher downside risk. Again, this is largely due to the “payout”

time horizons of both companies.

Table 4: Time Horizons and Reasoning of Zillow and Trulia

Increase:

SHORT TERM Acquire attractive target Hold and gain

Decrease:

SHORT TERM Lose value (expected);

Strong position to rebound Cash out holdings

Increase:

LONG TERM

Acquire attractive target;

Raise value of Trulia (in line

with expectations of Zillow)

Miss out on profits

Decrease:

LONG TERM

Drop, as expected;

Acquired competitor at

discount

Miss out on profits

Benefit Drawback

Since the analysis of this deal relies on two main assumptions, overvaluation and each

companies’ internal awareness of the over exuberance of the market, a rational valuation of

Zillow and Trulia must be done.

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Valuations

Discounted Cash Flows Model

Although the Discounted Cash Flow (DCF) valuation model is generally a sound method,

it does not apply well in this instance. Non-financial variables, such as unique monthly visitors,

impact the valuation of Internet companies much more than financial results (Bartov, Mohanram

& Seethamraju, 2002). Moreover, a DCF analysis of these two firms would require too many

assumptions, with too little confidence of their reliability. In addition to the myriad of cash flow

assumptions that must be modelled, it is our contention that even the required rate of return

would be unreliable. Current assumptions of each company’s volatility must be based on factors

related to their stock price, rather than the internal workings of the firm. Because of the obvious

speculative nature of internet stocks (ZIllow and Trulia, in particular) this key factor

underpinning any DCF valuation fails to guide investors appropriately.

Comparables Approach

With a DCF valuation deemed too unreliable, the next step in evaluating this deal is to

look at comparable firms. These comparisons help to direct our analysis towards further

investigations.

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Table 5: Comparables Valuation

Stock Market Cap (millions) Price/Sales

Zillow (Z) $4,205 15.96x

Trulia (TRLA) $1,508 7.03x

Move

(MOVE) $840 3.48x

Angie’s List $384 1.28x

Facebook $207,250 17.2x

Google $376,420 5.81x

CNN

“Tech30”1 - Avg = 5.51x

Zillow

(implied)2 $1,782 $52.24/share

Trulia

(implied) $1,431.65 $38.37/share

The table 5 demonstrates that the indication of overvaluation perhaps has some merit. Zillow is

currently occupying the same optimistic air as a company such as Facebook, and Trulia is

generating greater future ambition than even Google. Obviously, there are very different factors

underpinning market sentiment of each company yet we can clearly see that market sentiment,

rather than current revenue and cash flows, are guiding Zillow and Trulia share prices. So if we

1 The CNN “Tech30” is a theoretical portfolio that CNN.com created as an analysis of the

technology sector. It is 30 companies that are regarded as the “30 most important tech stocks in

the world”. 2 Based on a price-to-shares ration of 5.5

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can surmise that current prices are indicative more of investors expecting Zillow and Trulia to

“win the market” than it falls to reason that we must then investigate whether or not the

probability of that outcome is reasonable.

Rational growth projections

Our next step is to apply inductive reasoning to the current market valuation. By “reverse

engineering” the cash flows required to justify the current price we can gain further insight into

the conclusions suggested by the comparison evaluation.

Table 6: Rational Growth Projections

Revenue

Estimate 2014 324.1M 260.3M*

Free Cash Flow

Estimate 2014 19.6M 16.6M*

Percentage of Revenue 6.05% 6.37%

Share Price

(Oct. 31/14) 108.73 46.65

Required CF to justify

Share Price & O/S

(Total Rev*%CF)

$4,381.82M $1,880.0M

10-Year Implied CAGR 72% 60%

15-Year Implied CAGR 43% 37%

Estimate based on quarterly growth, as Trulia did not provide an estimate in their 3rd

quarter report due to the pending acquisition with Zillow.

As table 6 clearly shows, under current business structure both companies would have to

maintain an exceptionally high growth rate to achieve cash flows in line with current

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expectations. In and of itself, this could be acceptable to some investors who anticipate positive

synergies and cost savings from the proposed deal. However, it does further indicate that current

estimates are not properly valuing these two companies, either together or apart. With that in

mind, it is therefore important to move into a deeper analysis of the “rational” price of the

proposed combined company.

A Schwartz Moon Model

In their 2000 paper “Rational Pricing of Internet Companies” Schwartz and Moon

theorize a process of evaluating the underlying assets of high growth technology companies. This

approach has a great deal of application with regards to Zillow and Trulia, as both companies

have net negative earnings in a segment defined by market dominance rather than efficient

business functions (typical of “marketplace” and “listings” websites). By factoring in present

values for business fundamentals, such as revenue, cash available, costs as percentage of revenue

and tax rate, we are able to forecast ending enterprise value and likelihood of operational

concerns. It uses a stochastic forecasting approach coupled with a Monte Carlo analysis to

approximate rational cash flows of companies without “typical” business structures or returns.

Essentially, by focusing on key volatile factors (specifically growth rate and costs as percentage

of revenue) the model can tell us roughly where current valuations fall probabilistically.

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Figure 2: Ending Enterprise Values

In our model, we used Zillow, as the acquiring firm for our initial conditions. The company’s

growth rate, beginning revenue and cost structure were established from their public history with

volatility of growth and costs assumed based on stock price and historical financial data,

respectively. We then set the “unfettered growth” horizon at 3 years3 and forecast date for 40

quarters (10 years). Due to high variance of costs as percentage of revenue- both inside the

company and the industry generally- the model established limits of 60% and 120% in any given

quarter. We also established that an ending Enterprise Value could not be below zero.4

3 What we mean here is simply the point at which the company begins to resemble a “typical”

firm and begins the growth drift towards general volatility levels. 4 Admittedly, this model is not able to account for the effect on business operations from debt

capital. This is the most likely capital infusion for a company such as Zillow and in the model

simulations that result in zero cash available would, in real life, result in the company raising

capital. It is also, therefore, unable to factor what effect, if any, this would have on share price.

Thankfully, there exist a convenient proxy for such a scenario. Amazon (AMZN) has rarely

posted profits but still maintains strong confidence from investors, and currently has a Price-to-

Sales ratio of 1.59. Even if Zillow can hold investor confidence without generating profits for the

next decade the company would still need to maintain a 24.7% Revenue CAGR in that time

($2.625B in Year 10).

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Table 7

Average Cash Flow + Ending EV $806M5

Average Ending Share Price $24/share

95% Confidence < $98.20/share

Probability of Further Cash Required 43.9%

Figure 3: Enterprise Value Outcomes

5 10 trials were performed with 1000 simulations each

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What if the deal fails to close?

If the proposed deal falls through for any reason, bearish investors should be excited. As

a result of announcing the deal both companies have clearly “signalled” their strategies and

internal valuations. Therefore, a failed acquisition will likely result in depressed stock prices and

perhaps even a quick cash acquisition of one company or both (likely Trulia). At this point,

evidence points to a stock price drop regardless with any buoyancy coming from positive

investor sentiment. If that optimism were to be threatened, or worse, there could be a steep drop

for both companies and particularly for Zillow.

Assumptions required to invest in the combined company

As our analysis has shown, the public is very likely overvaluing Zillow, Trulia and the

proposed combined company. Investors should be concerned about Zillow’s cost structure and

the growth projections that underpin the current valuation. As it stands, there are several “levers”

which investors must project will turn positively for the combined company in order to invest.

However, if an investor is contemplating a long position in the new, combined company there

are reasons to do so. Assuming that the regulatory threat does not actualize, investors who

believe strongly that the combined firm will positively impact operational efficiency, achieve

substantial growth through market dominance and overall market growth and benefit from

network effects (such as pricing power and data IP) should invest.

Trading Strategy

Our investigation has uncovered greater concerns regarding risk and expected returns.

Along with the strong signals that the acquisition is sending to the market it is our contention that

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the share prices of Zillow and Trulia will decline in the short term. For this reason, our

recommended strategy is to execute a Bear Spread options approach.

Table 8: Put Options to Buy

Put Options to Buy

Strike Price $100.00 $52.50

Expiration May 2015 March 2015

Cost (100 shares) $1,780 $1,160

Put Options to Sell

Strike Price $70.00 $35.00

Expiration May 2015 March 2015

Cost (100 shares) $350 $480

Total Cost $1,430 $680

This will capitalize on the expected drop in share price while hedging against the smaller

probability that the value of the two companies will increase. The following graphs outline our

Bear Spread strategy for Zillow and Trulia with options expiring in May 2015.

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Figure 4: Bear Spread Options Approach

In the long-term, we recommend a short position in Zillow as the public becomes more aware of

overly ambitious growth projections and the likely less-than-optimal synergy effects.

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Appendices

Appendix 1 - Acquisition Patterns by the Top 3 Competitors in the Online Real Estate Listing

Market

Buyer Target Price Date

Zillow Trulia $3.5 billion in stocks 28-Jul-14

Zillow Retsly Software Undisclosed 16-Jul-14

Zillow Mortech $15.9 million in cash and stock ($12M in cash) 30-Nov-12

Zillow NMD Interactive $50 million in cash 26-Aug-13

Zillow HotPads $16 million in cash 14-Dec-12

Zillow The Guru Group Undisclosed 31-Oct-12

Zillow RentJuice $40 million in cash 1-Jun-12

Zillow Diverse Solutions $7.8 million in cash and stock ($5,540,000 in

cash) 31-Oct-11

Zillow Postlets Undisclosed 11-Apr-11

News

Corp Move $950M, all-cash tender offer

Move Point2 Technologies Undisclosed 4-Sep-14

Move FiveStreet Undisclosed 16-Oct-13

Move ABC Holdings $2.3 million in cash 2-May-13

Move Relocation.com $11.5 million in cash 11-Oct-12

Move TigerLead Solutions $22 million in cash 4-Sep-12

Move SocialBios.com Undisclosed 18-Jul-11

Move Threewide Corp $13.1 million in cash 21-Sep-10

Move Star Relocation

Network Alliance

Undisclosed amount in stock & contingent

payments 31-Jan-08

Move Eternity

Entertainment Undisclosed 11-Dec-02

Move MYCO International Undisclosed 11-Dec-02

Trulia Market Leader $345.5 million in cash and stock ($164,098,842

in cash) 20-Aug-13

Trulia Movity.com Undisclosed 21-Dec-10

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Appendix 2 - Perceived competitiveness

There has been some concern by real estate agents that combining the leaders in the

market could give them high pricing power and represent a threat to the current business model.

This concern also raised questions about the probability of a favorable answer from the FTC

regarding the acquisition. However, offline alternatives still account for the majority of spending

in real estate advertising and online competition is still strong. Indeed, News Corp recently

announced the acquisition of Move, Inc. If this deal closes, the resources available to Move, Inc

would allow the company to grow and compete for market leadership. Furthermore, some predict

that this announcement increases the chance that the Zillow/Trulia acquisition will close as

strong competition weakens any regulatory opposition.

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Appendix 3 – Additional Acquisition Cost per New User Trend

# Unique

monthly

visitors

Visitor

increase from

previous year

Costs

reported (in

thousands)

Cost increase

from previous

year (in

thousands)

Additional

cost / new

visitor

Trulia

2011 14,776 $44,285

2012 23,145 8,369 $77,604 $33,319 $3.98124

2013 38,809 15,664 $167,871 $90,267 $5.762704

Zillow

2011 21,452,250 $65,056

2012 33,975,917 12,523,667 $111,053 $45,997 $0.003673

2013 54,111,167 20,135,250 $214,494 $103,441 $0.005137

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References

Bartov, E., Mohanram, P., &Seethamraju, C. (2002). Valuation of Internet stocks—an IPO

perspective. Journal of Accounting Research, 40(2), 321-346.

Homberg, F., Rost, K., &Osterloh, M. (2009). Do synergies exist in related acquisitions? A

meta-analysis of acquisition studies. Review of Managerial Science, 3(2), 75-116.

Kummer, C., & Steger, U. (2008). Why merger and acquisition (M&A) waves reoccur: the

vicious circle from pressure to failure. Strategic Management Review, 2(1), 44-63.

Perry, J. S., & Herd, T. J. (2004). Reducing M&A risk through improved due diligence. Strategy

& Leadership, 32(2), 12-19.

Shleifer, A., &Vishny, R. W. (2003). Stock market driven acquisitions. Journal of financial

Economics, 70(3), 295-311.

Schwartz, E. S., & Moon, M. (2000). Rational pricing of internet companies. Financial Analysts

Journal, 62-75.