WATER OUT OF TWO STONES - MASTERS OF INTERNATIONAL BUSINESS - The Economist
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WATER OUT OF TWO STONES
MASTERS OF INTERNATIONAL BUSINESS
EDWARD LEE DAVID ALDAMA SHU GAO
I. Introduction
In 2012, Zillow CEO Spencer Rascoff likened his newly launched business model to the task of
getting water out of a stone 1, a reference to his view of the industry’s trapped value and the
evaporation of company profit despite persistent expenditure. After two years, several
acquisitions, a significant capital raise, and consecutive years of earnings loss, Mr. Rascoff’s
latest solution is to simply try to get water from another rock. Yet, the market has continued to
favor the potential of Zillow and Trulia to profitably disrupt the real estate brokerage industry
with Zillow trading at a market price of $108.73 per share as of Oct 31 close and Trulia moving
in lockstep. We view this market expectation as fundamentally mispriced, principally due to their
weak position relative to their clients, suppliers, and competitors. The growth story of Zillow and
Trulia has been certainly noteworthy, but all good things must come to an end, some earlier than
others.
II. Deal Valuation
Which company is getting the better deal and why?
While every financial news pundit proclaimed Zillow’s acquisition of Trulia as a deal with a $3.5
billion price tag, the more relevant term to emphasize would have been the exchange ratio, fixed
at 0.444 Zillow shares for one Trulia share. As a stock-only transaction, the sole compensation
for Trulia shareholders will be 0.444 shares of Zillow for each share of Trulia once the
transaction closes.
1
“CMLS question and Zillow answer”, YouTube 0:59 -
https://www.youtube.com/watch?feature=player_embedded&v=mnwOcW53gK0
MASTERS OF INTERNATIONAL BUSINESS
EDWARD LEE DAVID ALDAMA SHU GAO
If we look at the stock prices of Zillow and Trulia, normalized as of October last year, there is a
trend of divergence up until deal announcement at the end of July (see green-shaded areas in the
exhibit below).
Zillow clearly outperformed Trulia over the nine months prior to the deal, giving Zillow the
negotiating advantage.
The table below shows the implied exchange ratio between the two companies steadily
decreasing in favor of Zillow, arguably showing that Trulia needed Zillow more than Zillow
needed Trulia.
MASTERS OF INTERNATIONAL BUSINESS
EDWARD LEE DAVID ALDAMA SHU GAO
Zillow also retained the option to purchase Move instead of Trulia, further adding to their
negotiating leverage. However, despite such leverage, Zillow paid a sizable acquisition premium
of 37%, if one uses the difference between the implied exchange ratio of 0.32 and the actual
exchange ratio of 0.44.
Of the 37%, a control premium is certainly included. Zillow will have clear preservation of
control in the newly created holding company Zebra HoldCo as shown in the tables below.
Effectively, Trulia shareholders will own one-third of Zebra HoldCo but hold only 15% of the
voting power.
Of the 37%, a sizable synergy premium is also included. However, the risk that the synergy
value will not materialize is shared with Trulia shareholders. Specifically, Trulia holds one-third
of the synergy risk.
Does the structure of the deal make sense for each company?
The structure of the deal, a stock-only transaction, makes sense for Zillow given its inflated
valuation prior to deal announcement. Trulia was similarly overvalued, and its market price was
highly correlated with Zillow’s price even prior to the deal. We will discuss the reasons why we
MASTERS OF INTERNATIONAL BUSINESS
EDWARD LEE DAVID ALDAMA SHU GAObelieve these companies to have been overvalued at the time of deal announcement --as well
as at present-- in a subsequent section of this report. If the outlook of Trulia’s shareholders on
the industry and Zillow’s management is favorable, the deal structure makes sense for Trulia
since a stock-only transaction results in less value destruction than a cash-only or cash-stock
transaction.
There is also an accounting rationale for a stock-only acquisition versus cash. When two
companies merge via a stock-only transaction, the book values of the assets and liabilities are
combined rather than the market values (“pooling of interests method”). No goodwill is created
or amortized by the acquisition. When companies merge via a cash transaction, goodwill is
created and amortization expenses are generated (“purchase method”). Thus, earnings per share
will be higher through the use of a stock-only transaction, certainly important for a company
straddling the profitability line.
What will the futures likely be for each company on a standalone basis if the transaction
fails to close?
Both companies are likely to be worse off in terms of their financial and strategic position if the
transaction fails to close. In addition to losses from sunk transaction costs and termination fees,
Zillow and Trulia will fail to materialize on critical cost savings in sales, marketing and R&D
expenses.
From a strategic viewpoint, the merger has become essential to Zillow and Trulia due to the
entrance of News Corp as a heavyweight competitor through its acquisition of Move Inc. Failure
to consolidate would present News Corp a clear opportunity to outmuscle and dominate the
MASTERS OF INTERNATIONAL BUSINESS
EDWARD LEE DAVID ALDAMA SHU GAOspace. Also, an implicit strategic objective behind the Zillow-Trulia merger is to gain “mind-
share” among realtors through a prospective monopoly on the mind-share of consumers. Both
types of mind share are critical to profitability and failure to achieve either would severely limit
the futures of both companies.
Based on the companies’ present combined market valuations, what assumptions about
their future would you have to make in order to buy stock in the combined company?
Bundled within current market valuations of Zillow and Trulia include market expectations
surrounding (1) deal completion, (2) structural change in the real estate industry, (3) the
competitive landscape, and (4) synergy value from the merger.
The current market price of Trulia discounts the likelihood of the merger closing by $2.36. We
view the probability of deal completion as very likely despite two routine acquisition hurdles,
FTC approval and shareholder approval from each company.
While some have voiced concerns that a merged Zillow-Trulia might obtain monopolistic pricing
power, the structure of their current revenue model, whereby their paying subscribers are
effectively their content providers, refutes this possibility. Both Zillow and Trulia receive the
majority of their listings data from MLS systems. The threat of price increase is generally
neutralized by the threat of listings withdrawal. Thus, on a practical level, the FTC should see no
anticompetitive issue arising from the merger. Unfortunately, such a revenue structure does not
bode well for Zillow or Trulia in a strategic sense, which we will discuss later.
MASTERS OF INTERNATIONAL BUSINESS
EDWARD LEE DAVID ALDAMA SHU GAOThe ultimate objective of the FTC is to protect the consumer, in this case, current or prospective
homeowners. In fact, disintermediation of the MLS structure has been implicitly welcomed, as
evidenced by a 2008 mandate by the U.S. Department of Justice 2 requiring all MLS systems to
allow membership and access to Internet-based competitors.
Also, despite two shareholder lawsuits currently filed against Trulia, we view both cases as
routine and akin to lawyers chasing after ambulances. There is shared incentive among all
stakeholders to close the deal as quickly as possible. The boards of both companies have
approved the deal.
The current market price of Zillow assumes that the present structure of the U.S. real estate
industry must fundamentally change; that is, that MLS systems will cease to exist in their current
form and function.
The market opportunity for real estate portals like Zillow, Trulia, and Realtor.com (ZTR) is
significant. Out of $1 trillion+ in annual real estate transaction volume, ~$60 billion in
2
http://www.justice.gov/atr/cases/nar.htm
MASTERS OF INTERNATIONAL BUSINESS
EDWARD LEE DAVID ALDAMA SHU GAOcommissions flow to real estate agents and brokers. Agents and brokers then spend ~$14 billion
on marketing. Of that $14 billion, only ~$1 billion is currently captured by ZTR portals. In other
words, the pie is presumably large for the taking.
*ORED: Online Real Estate Databases, or portals, such as Zillow, Trulia, and Realtor.com
Yet, the current structure of the industry, fragmented with MLS systems, prevents Zillow and
Trulia from capturing a larger share. MLS systems have long been a pillar of the U.S. real estate
industry, facilitating information exchange between brokers and agents. As an advertising
medium, every MLS has given their member agents significant pricing and market power by
perpetuating the feeling among homeowners that their property will not sell unless placed on an
MLS. It is a key reason why average commission fees remain high in the US. While some
international markets such as Australia have eliminated the need for buyer agents, the MLS
ecosystem in the US provides sustenance for their continued existence.
MASTERS OF INTERNATIONAL BUSINESS
EDWARD LEE DAVID ALDAMA SHU GAOZillow and Trulia receive the majority of their content from MLS systems across the nation.
Under their current revenue model, realtors associated with large MLS systems incur less fees
and receive preferential placement due to their substantial negotiating power as suppliers, while
real estate agents not associated with such MLS systems constitute the bulk of their revenue. In
other words, big-ticket MLS systems obtain subscriber benefits at little to no cost while smaller
realtor networks and individual realtors are “milked”, effectively killing off or alienating their
primary revenue stream. One example of a large realtor network exerting its leverage as a
supplier is Coldwell Banker of Realogy, whose agents are able to place listings on Zillow and
eight other portals under similar or lesser fees than if the agents subscribed to the portals
individually. 3 Similar relationships with other large realtor networks have prevented both Zillow
and Trulia from pricing their services in an optimal and sustainable manner.
3
Coldwell Banker’s “2014 - 2015 Fab Plus Featured Agent Branding Program”
MASTERS OF INTERNATIONAL BUSINESS
EDWARD LEE DAVID ALDAMA SHU GAOIt is only when realtors cease to have the MLS negotiating lever that Zillow and Trulia can
become profitable. This would happen only if realtors switched en masse from MLS systems and
subscribed to either Zillow or Trulia, a so-called tipping point whereby the value of Zillow or
Trulia as a lead-generating platform becomes overwhelming great due to consistent dominance
in consumer mind share, and the majority of realtors recognize them as such. Zillow has bet on
reaching this tipping point, and, at current valuations, the market concurs, albeit to a decreasing
degree over the past few months.
We view the possibility of Zillow reaching this tipping point as highly unlikely before or after
the merger. Although the status quo will undergo further change with respect to the MLS
systems, we see the resulting profits of disintermediation flowing to the firm best positioned to
capture not only consumer mind share but also realtor mind share. That firm is not Zillow-Trulia.
MASTERS OF INTERNATIONAL BUSINESS
EDWARD LEE DAVID ALDAMA SHU GAOThe current market price of Zillow does not sufficiently discount for the competition posed by
Move Inc, operator of the website Realtor.com and recently acquired by News Corporation.
Since 1996, Move Inc has been in partnership with the NAR, allowing Realtor.com to source its
listings data directly from nearly all 800+ MLS systems in the US on a timely and accurate basis.
We view this as a critical advantage for Move Inc.
As a partner of the NAR, Move Inc is better positioned than Zillow and Trulia to negotiate with
every MLS system and to coordinate a mutually beneficial relationship. In turn, News
Corporation can bring tremendous value to MLS systems with its financial resources, an
immediate transaction-ready audience, and global cross-promotional opportunities. 4
Like Zillow-Trulia, Move Inc is dependent on the eventual disintermediation of the MLS. The
key difference, however, is that MLS systems will more readily change if they can dictate the
terms of their own disintermediation. We see Move Inc and the NAR laying the groundwork for
this to happen immediately after the News Corp acquisition of Move Inc closes this year.
Finally, the actual synergy value of the Zillow-Trulia merger is highly questionable. Pricing
power will continue to be restrained. Overhead redundancies may be streamlined, but marketing
expenditures are likely to remain elevated. There will be a greater consumer audience but
considerable overlap as well. On the other hand, News Corps’ acquisition of Move Inc has
various complementary aspects. Move Inc reaches a new plateau of audiences, reduces
marketing expenditure, and leverages the News Corp technological platform.
4
“An Open Letter to the Industry” - by Move on Sep 30, 2014 http://industry.move.com/letter/
MASTERS OF INTERNATIONAL BUSINESS
EDWARD LEE DAVID ALDAMA SHU GAOValuation Scenarios
We have modeled four stylized scenarios, which we believe illustrate the possible paths of
market evolution. All scenarios assume a realtor pool of 1.1 million agents, in line with NAR
estimations. For scenarios in which “market disruption” is modeled, immediate attrition of 25%
of this realtor pool is assumed.
All scenarios were constructed in “top-down” fashion; first, total subscriptor volume was
calculated, and then allocated to market participants, with 0.444 subscriptors being allocated to
Trulia per Zillow subscriptor. This assumption stems from the high confidence we have
regarding the Zillow-Trulia merger deal close.
Scenario 1: Market capture by Zebra HoldCo
Likelihood: Unlikely
In this scenario, we model the following possible outcome: the Zillow-Trulia merger in the
medium run by and large, displaces MLSs. This market disruption leads to increased pricing
power for the new incumbent, as both MLSs and realtors --on an individual level-- are left with
little option but to do business through and advertise on Online Real Estate Databases (OREDs),
MASTERS OF INTERNATIONAL BUSINESS
EDWARD LEE DAVID ALDAMA SHU GAOparticularly Zebra HoldCo --the Zillow/Trulia tag team. Thus, ARPU steadily increases for this
company, in line with newly gained market power.
We assume in this scenario that Zebra HoldCo --the Zillow-Trulia tag team-- captures 80% of
the market share within two years.
The mechanics of this market capture are left ambiguous --scale, for instance, could enable
innovative platform developments that propel greater consumer loyalty. Market dominance,
however, would likely arise from endogenous factors: a tipping point reached on the consumer
mind-share front would “herd” realtors into the fold of Zebra.
Subscribers CAGR% 39%
(2014-2018)
ARPU CAGR% 6.1%
(2014-2018)
Annual SG&A Synergies $250M
Zebra Share Price $121
Scenario 2: Market capture by Move
Likelihood: Very likely
In this scenario, as in the above, market disruption is quite quick, and drastic. OREDs take over
the revenue pie, and ARPU takes on a steep upward trajectory --as realtors move en masse from
MLSs to online service providers. In contrast to Scenario 1, however, Move Inc. captures 80% of
the market, due largely to a marketing push enabled by News Corp’s media channels. This leaves
only 20% of the pie for Zebra HoldCo.
Subscribers CAGR% 7%
(2014-2018)
MASTERS OF INTERNATIONAL BUSINESS
EDWARD LEE DAVID ALDAMA SHU GAOARPU CAGR% 2.5%
(2014-2018)
Annual SG&A Synergies $10M
Zebra Share Price $58
We believe this market scenario to be the only one with very high likelihood among those
modeled. The reasons we believe this scenario to be more likely are twofold: first, we indeed see
the US Real Estate market as being ripe for disruption. High agent commissions and a segmented
intermediation structure --with buyer’s agents, seller’s agents, and brokers all getting a piece of
the revenue pie-- are testament to the existence of extraordinary economic rents up for the taking.
Secondly, we believe that the economic moat around Zillow’s current “market incumbency” to
be quite flimsy. If someone is to capture the economic rents that the US housing market affords,
Scenario 3: Duopoly
Likelihood: Likely
As in the above scenarios, market disruption takes hold, yet the revenue pie proves large enough
for two competing OREDs to survive. Both Zebra HoldCo and Move Inc. capture a 50% market
share in this scenario, and revenue streams are split accordingly. ARPU evolves like in the first
two scenarios, as MLSs succumb to the new market incumbents
.
Subscribers CAGR% 27%
(2014-2018)
ARPU CAGR% 2.8%
(2014-2018)
Annual SG&A Synergies $50M
Zebra Share Price $75
MASTERS OF INTERNATIONAL BUSINESS
EDWARD LEE DAVID ALDAMA SHU GAOScenario 4: MLS retain pricing/market power
Likelihood: Unlikely
In the fourth scenario modeled, MLSs continue to dominate the market, and OREDs continue to
struggle. Revenue and earnings trajectories for both Zebra HoldCo and Move Inc. mirror the
market reality of the past few years, as market disruption fails to fully materialize. ARPU
stagnates, as ORED pricing power stays flat, and both companies are incapable of dialing back
marketing and sales expenditures.
Subscribers CAGR% 7.7%
(2014-2018)
ARPU CAGR% (2014- 1.7%
2018)
Annual SG&A Synergies $5M
Zebra Share Price $51
MASTERS OF INTERNATIONAL BUSINESS
EDWARD LEE DAVID ALDAMA SHU GAOIII. Interest rates, real estate transactions, valuation implications
On the surface, the horizon looks bleak for the American housing market, which hasn’t regained
its pre-crisis momentum. Additionally, sales of new homes have been very volatile this year. 5
Shares of publicly-traded homebuilders, to boot, are down YTD, around 7.9%. 6
Cash buyers --many of them speculative or real-estate investors-- have been retreating steadily
from the market, as foreclosure properties become scarcer. 7 This means that the sensitivity of the
housing market to interest hikes will increase, which has fed fears of a market crunch happening,
should interest rates rise rapidly.
However, we believe that market signals regarding the future of interest rates are mixed. As
lately as this week, for example, investor’s positions on two-year Fed futures were net-long,
indicating an expectation of increasing bond prices. 8
Although the Fed’s “dot plot” --the expectations of the members of the rate-setting committee--
points to an aggressive rate hike, the market seems to expect a much less steep rate-increase
schedule (see graph below).
5
http://www.washingtonpost.com/blogs/wonkblog/wp/2014/09/22/cash-buyers-retreat-from-housing-
market-cooling-home-sales/
6
Ibid.
7
Ibid.
8
Susanne Walker, Investors Whipsawed in Treasury Futures as Fed Optimism Rises, Bloomberg,
October 31, 2014, http://www.bloomberg.com/news/2014-10-31/investors-whipsawed-in-treasury-futures-
as-fed-optimism-rises.html.
MASTERS OF INTERNATIONAL BUSINESS
EDWARD LEE DAVID ALDAMA SHU GAOWhen in doubt, they say, trust the market. In line with the market, we believe interest rates will
increase over the coming years, but they will follow a “slow and steady” trajectory. This should
leave ample space for pent-up housing demand to continue to propel the housing market upward.
Eventually, rising mortgage rates will take their toll, but this will only happen in the medium to
long runs.
Our modeling scenarios reflect our macro assumptions: there will be no noticeable dips in the
housing market due to rising rates --at least in a two to three year window-- in our estimation.
IV. Trades
Trade 1
The current price of Trulia over discounts the likelihood that the deal will close within six
months, presenting an opportunity for merger arbitrage.
• Long Trulia 1 share
• Short Zillow 0.444 shares
MASTERS OF INTERNATIONAL BUSINESS
EDWARD LEE DAVID ALDAMA SHU GAO*Target and acquiring firm prices based on Friday, Oct 31 close
• Risk: Counteroffer for Trulia by media company
Trade 2
The current prices of Zillow and Trulia significantly overvalue the likelihood that Zillow and
Trulia, either separate or combined, will have the tools to disintermediate the MLS and profitably
compete with Move Inc.
• Short sale of Zillow
• Target price: $64
• Cover price: $80
SCENARIO Z-T PRICE PER SHARE
(2) Market capture by Move (Very likely) $64
(3) Duopoly between Move and Z-T (Likely) $80
We expect the price to fall to $64, but our conservative profit limit is $80.
• Risk: Offer for Zillow-Trulia by media company (e.g. Yahoo or Google)
MASTERS OF INTERNATIONAL BUSINESS
EDWARD LEE DAVID ALDAMA SHU GAOEXHIBIT 1A: SCENARIO 1 REVENUE BUILD MASTERS OF INTERNATIONAL BUSINESS EDWARD LEE DAVID ALDAMA SHU GAO
EXHIBIT 1B: SCENARIO 1 ZEBRA PRO-FORMA-DCF
MASTERS OF INTERNATIONAL BUSINESS
EDWARD LEE DAVID ALDAMA SHU GAOEXHIBIT 2A: SCENARIO 2 REVENUE BUILD MASTERS OF INTERNATIONAL BUSINESS EDWARD LEE DAVID ALDAMA SHU GAO
EXHIBIT 2B: SCENARIO 2 ZEBRA PRO-FORMA-DCF
MASTERS OF INTERNATIONAL BUSINESS
EDWARD LEE DAVID ALDAMA SHU GAOEXHIBIT 3A: SCENARIO 3 REVENUE BUILD MASTERS OF INTERNATIONAL BUSINESS EDWARD LEE DAVID ALDAMA SHU GAO
EXHIBIT 3B: SCENARIO 3 ZEBRA PRO-FORMA-DCF
MASTERS OF INTERNATIONAL BUSINESS
EDWARD LEE DAVID ALDAMA SHU GAOEXHIBIT 4A: SCENARIO 4 REVENUE BUILD MASTERS OF INTERNATIONAL BUSINESS EDWARD LEE DAVID ALDAMA SHU GAO
EXHIBIT 4B: SCENARIO 4 ZEBRA PRO-FORMA-DCF
MASTERS OF INTERNATIONAL BUSINESS
EDWARD LEE DAVID ALDAMA SHU GAOMASTERS OF INTERNATIONAL BUSINESS EDWARD LEE DAVID ALDAMA SHU GAO
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