Zillow & Trulia Won't Shake Up the American Real Estate Market

University of St Thomas Opus College of Business, 1

Zillow & Trulia Won’t Shake Up the
    American Real Estate Market
        - why investors should be short both firms -

        by Willis Krumholz, Erin Bakken, & Nate Stephens

University of St Thomas Opus College of Business, 2

A. Executive (abstract) summary

The combination of Zillow (Z) and Trulia (TRLA) will suffer, not because of deal structure or

lack of synergies, but due to the defunct business model on which both firms are built – real

estate listing without operating a brokerage. Such a business model has kept Zillow and Trulia

from actually upending the inefficient American real estate market and causes the firms to be far

too reliant on large brokers to gain increased pricing power in the event of a merger. Further,

because Zillow and Trulia have failed to change the way American homes are bought and sold,

the leads generated by the two sites are subpar, even when compared to broker’s sites.

For these reasons, and because the market is not as deep as bulls suspect, the bullish case for

Zillow and Trulia’s current valuations is inherently flawed. Expect both shares to drop as the

merger draws near, and for shares in the combined firm to sell at a deep discount by mid-2015.

B. The American real estate market’s inefficiency

America’s real estate market is due for a change, but the change won’t come from Zillow or

Trulia. While internet firms have made travel easier and cheaper for consumers (Expedia) and

driven down the fees charged by stock brokers (E-trade), Zillow and Trulia have yet to shake up

America’s real estate market – in fact, they are very much part and parcel of the old way of doing

things.

American real estate transactions levy some of the highest costs on consumers in the world –

around 6% of the transaction price is paid directly by the seller to the seller’s agent, who then

splits that 6% with the buyer’s agent.1 A study by economists at the University of Chicago

(2005) noted that though consumers who left their real estate agent behind fared better

1
    BLOOMBERG BUSINESSWEEK, Why Redfin Zillow and Trulia haven’t killed off Real Estate Brokers, March 7, 2013.

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financially, most Americans were reticent to ditch the agents – despite the high fees – because

buying or selling a house is such a monumental decision for most consumers.2

As a result, we have the current system that we do today: Agents charge exorbitant fees to help

consumers buy or sell a home, and brokerages pool resources and marketing costs for agents

through increased economies of scale.

C. Zillow and Trulia’s business model

It is within this context that the business model of Zillow and Trulia should be examined. Both

firms receive house listings from the brokers, or through third party data vendors (ListHub and

Point2) that have access to various multiple listing services (MLS), and then charge real estate

brokers and agents for the privilege of having a particular agent listed prominently on a house-

listing. Fundamentally, the firms were a bet that more Americans would use the internet to buy

and sell homes.

That bet has failed to pay off. Though many Americans look at houses on the internet, most still

find a house using conventional measures – around 80% of house-buys are through referrals3.

            Home Purchases Based on Referrals
                          Referral     Non-referral

                                20%

                                       80%

2
    Id.
3
    CNBC, Realtors Shouldn’t Worry About the Zillow-Trulia Deal: Pros, July 28, 2014.

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Though this number might be brought down a bit by millennials entering the housing market,

high student debt and a slow recovery from the depths of the 2008 crisis means this might not

happen any time soon.

More fundamentally however, Zillow and Trulia have built themselves upon the existing system

of real estate transaction, which is their fundamental flaw. Both firms are being valued as if they

will supplant the brokerages, but by Zillow and Trulia’s own current direction and business

model, they are subservient to the large brokers.

          (1) Why Zillow and Trulia’s business model is flawed

Zillow and Trulia’s affiliation with the old way of buying and selling real estate will continue to

leave either firm unable to monetize web traffic. There are two reasons for this:

First, as stated above, most Americans still don’t find the home they ultimately purchase on the

internet. Most important, even when Americans use the internet to find a home, they are very

unlikely to use Zillow or Trulia’s featured “premier agent.” Given the underpinnings of

America’s two-agent 6% fee system, this makes sense – if the inefficiencies in the market can be

explained by the need for an agent that is known and trusted, and the feeling that purchasing a

house is a risky endeavor, consumers are not likely to chose the featured agent on a Zillow or

Trulia listing. They will instead opt for the agent their parents used, or the agent that lives down

the street.

This translates into poor leads for brokers that advertise on either real estate listing site. In

general, only 10% of leads for buyers, and 5% of leads for sellers4, come from the internet (this

includes broker’s own sites). Looking at Zillow and Trulia specifically, the lead-numbers are

4
    Barrons

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even worse. Brokers such as Realogy Holdings (RLGY) have better leads than Zillow or Trulia,

and the leads on Realogy sites are growing at a much faster CAGR than those generated by

Zillow or Trulia.5

Part of the problem, for example, is that about half of Zillow’s web traffic isn’t even looking at

homes that are for sale; rather the traffic is focused on using either firm’s pricing algorithm to

value homes that are not on the market.6 Bulls point out the audience here, but the reality is that

Zillow and Trulia have no way of monetizing web traffic unless they generate better leads for

brokers, and again, given the old system that relies on personal relationships and trust, Zillow

and Trulia are fighting a losing battle.

The second reason Zillow and Trulia lack the ability to monetize web traffic is because they do

not have direct access to the MLS listings of brokers without the broker’s compliance. Realogy,

the nation’s largest brokerage with brands like Coldwell Banker, Sotheby’s, and Century 21,

provides a good example of Zillow and Trulia’s lack of pricing power.

A Realogy presentation for agents, noticed by Andrew Left’s Citron Research, touts Realogy’s

“Fab Plus” (see Appendix 8) program where participating agents can block competing agents

from their listings, and where agents receive a 90%-plus discount when being featured as a

premier agent on the listing.

Realogy is the largest US broker, with 20% market share, and they supply anywhere from 15-

30% of Zillow and Trulia’s listings.7 Given the aforementioned issue of leads, Zillow needs

Realogy just as much or more than Realogy needs Zillow. This explains the “bulk discount” that

5
  CITRON RESEARCH, Zuliagate – The Big Secret, July 26, 2014.
6
  BARRON’S, Zillow Shares Could Fall By Half. August 9, 2014.
7
  Supra, note 5

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has been given to Realogy by Zillow, Trulia, and Realtor.com – and discounts such as this likely

exist for the other large brokers as well (also note that Zillow and Trulia do not include discounts

in their average revenue per user “ARPU” metrics).8

           (2) The bulls are wrong about market size

Zillow and Trulia’s inability to monetize web traffic due to (1) poor leads, which can be

explained by the real estate market’s quirks, and (2) reliance on the brokers for house-listings,

discredits the bull-case on Zillow and Trulia’s pricing power. Next, for the two listing firms’

current stock prices to be justified, 50%+ revenue growth needs to continue throughout 2015 and

into 2016.

Further, the companies are currently being valued using non-GAAP measures that discount

employee stock compensation (common on the Street when valuing tech companies with huge

growth potential) with the reasoning being that huge year-on-year gains in revenue growth will

offset any dilutive effects that a stock-plan has on share value.

Yet the bull’s estimation of market size – an $8-10 billion real estate marketing market, of which

Zillow and Trulia only occupy around $400 million combined, and of Zillow’s potential for

100,000 unique premier agents – is inherently flawed.

First, as mentioned previously with the Realogy example, large brokers are beginning to limit the

ability of other broker’s agents to appear on their listings – this factor alone significantly cuts ad

inventory available to Zillow and Trulia.

8
    Supra, note 6.

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Second, the two firms will begin to reach market saturation in 2015, as the agents willing and

able to pay for a spot, but not affiliated with a large-enough brokerage to have bargaining power

over Zillow and Trulia, is a limited pool that has already been almost fully tapped.

We project saturation in 2015 based on the following: Currently the U.S. has 500,000 active real

estate agents, though only a minority do enough business to advertise on Trulia or Zillow. We

expect the number of agents willing to advertise on Zillow and Trulia to be around 15-20%, or

75,000-100,000. Given Zillow’s current 55,000 premier agents, and Trulia’s 70,000 premier

agents (because Trulia charges less), and the firms’ assertion that only “modest” customer

overlap exists, the bull case that the market can sustain 100,000-plus fully-paying premier agents

seems unlikely.9 Again, this is because most agents are not active enough to buy ad space, and

many others are affiliated with the big

brokers who are getting discounts. In the

alternate, if Zillow and Trulia do have

overlapping customers, the bullish case for a

merger still suffers (also note the fact that

Zillow, the larger firm with more hits, has

fewer premier agents than Trulia, because it charges more – meaning that the unique customers

Zillow is “buying” numbers around 20,000 – that also seems to cool the bull-case).

D. The merger

It is within this context that Zillow and Trulia are merging, with .444 shares of Zillow stock

being offered for every 1 share of Trulia stock, amounting to around a 25% premium being paid

9
    HOUSINGWIRE.COM, PAA Research: Are Zillow’s advertising inventory problems escalating?, September 8, 2014.

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to Trulia shareholders. Trulia’s shareholders will comprise about a third of the shareholders in

the combined firm, with Zillow making up the rest – and Trulia management will remain on

under Zillow CEO Spencer Rascoff.

Because of the premium Zillow is giving to a company that is already overvalued by the market,

Trulia shareholders are getting the better deal. Conversely, Zillow shareholders will experience

a dilution of their share value.10

Regardless of whether Zillow is overpaying for Trulia, whether projections of cost reductions

and synergies will turn in the bull’s favor, and whether or not management will be able to get

along, the combined firm will suffer due to the fundamental flaws in the new firm’s

aforementioned business model.

In this light, the merger of Zillow and Trulia – both with identical business models – makes

sense. If anything, the merger is a last-ditch effort to survive, not a play to take over the market.

Even if Zillow and Trulia had a “monopoly” in the real estate listing market after the merger, the

real estate listing business model operated by Zillow and Trulia leaves them without the power to

monetize web traffic.

         (1) The future – low barriers to entry

No Zillow-Trulia monopoly will exist as Newscorp, Realogy, and Redfin will provide ample

competition. First, Newscorp’s (NWSA) purchase of Move Inc. (MOVE) for $950 million11,

which owns Realator.com, means that the beleaguered listing site that used to have sky high

10
   A positive aspect for Zillow shareholders, though, is the stock for stock aspect of the merger, meaning the price
of the merger will decline and fall in concert with the stock prices of both companies – which of course have been
tracking each other since the merger was announced.
11
   THE WALL STREET JOURNAL, News Corp to Buy Move Inc. for $950 Million, Sept. 30, 2014.

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valuations (Move traded at almost $500 per share but now trades in the low-teens) will have a

backer with plenty of spending power.

Newscorp has experience running listing sites in Australia, China, and Europe (where value is

provided because these regions do not have a well-developed MLS) and should be a direct

contender with Zillow and Trulia, though with a similarly flawed business model.

There are two reasons why there are low barriers to entry when competing under the current

business model: Essentially, Realtor.com is an ad campaign away from generating more

eyeballs, and the rise of Zillow over Realtor.com after increased marketing spend, and the recent

rise of Trulia’s popularity12, are a testament to this. Next, the value that Zillow and Trulia do

provide consumers, through their home pricing algorithms, have been so-far proven to be non-

patentable by a district court in Washington, and a US patent office review board.

Incidentally, while the entrance of Newscorp will make Zillow’s case before the Federal Trade

Commission (FTC) a sure bet, the resulting competition will stymie Zillow and Trulia’s attempt

to dominate the sweet spot of large-enough-but-not-too-large brokers who want to pay but don’t

have the bargaining power of Realogy and its peers.

        (2) The future – Realogy and Redfin

More powerful as a measure of market change though, will be the entrance of Realogy and the

continued value proposition to consumers offered by Redfin.

First let’s look at Redfin: Redfin was the original real estate listing site, and is also a brokerage,

but has grown much slower than Zillow or Trulia, as it actually intends to upend the American

12
  Zillow “cranked up” marketing expenditure and traffic jumped sharply in its June quarter: BARRON’S, Zillow
Shares Could Fall By Half. August 9, 2014.

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real estate market. Redfin leverages its internet presence to reduce marketing spend, and then

passes those savings on to consumers. Where a real estate transaction costs most Americans 6%,

Redfin costs 3%, and if the other agent in the transaction is not associated with Redfin that

agent’s buyer or seller gets a discount too (in the form of a rebate).

Redfin’s growth has been slow because it has moved city-by-city (just entering our city of

Minneapolis this last year) and hires agents on the ground who do all the things real estate agents

normally do – except that they are paid a salary (not a commission) and they receive a bonus

based on customer satisfaction. Naturally, Redfin has caught the ire of the rest of the real estate

industry, with many other agents refusing to inform their customers about Redfin listings. Yet

Redfin is still making progress, and plans a possible IPO in 2015.

The genius of Redfin’s business model is that they have no reliance on the old-school brokers

whatsoever. As a brokerage themselves they have direct access to MLS feeds and other broker’s

listings (they won an anti-trust case in 2005 that secured them this right), and their listings are

much more accurate and up-to-date when compared with Zillow’s or Trulia’s as a result.

So Redfin (1) actually creates value for consumers, (2) is not reliant on the other brokers for

listings as they are themselves a brokerage, and (3) if well-capitalized through an IPO they could

gain the eyeballs that Zillow and Trulia currently command.

Just as groundbreaking would be a traditional brokerage copycatting Redfin, but with the

existing agent-infrastructure already in place. Just this year, Realogy, again the nation’s biggest

brokerage, purchased ZipReality for $166 million, and plans on launching a website to compete

with Zillow and Trulia. Such a move would allow Realogy to create similar cost-efficiencies for

consumers as seen by customers of Redfin, and would allow Realogy agents to undercut the fees

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levied by competitors. Again, Realogy – as a brokerage – would have direct MLS access. In

other words, they would be a marketing campaign and a home-price algorithm away from

completely replacing Zillow and Trulia – all while having more accurate listings with no threat

to be cut off by competitors.

Might Zillow and Trulia become brokerages? There are a few reasons why this can’t happen.

First, such a move would completely upend either firm’s revenue base (which comes from the

brokers) and this is a move that would have to be done under the auspices of private equity, not a

publicly traded ownership. Second, building a brokerage is not easy – look at Redfin’s slow

growth – as agents must be trained and hired in each location in which the broker intends to

operate. In other words, there are actual barriers to entry to becoming a broker, unlike the low

barriers to entry that stand in the way of the brokers becoming what Zillow and Trulia are today.

Though Zillow CEO Spencer Rascoff refers to the brokers as “partners,” brokers don’t see things

the same way – Zillow and Trulia are completely replaceable. This is the firms’ Achilles heel.

As a result, we would only invest in the combined enterprise if the new firm moved to create a

brokerage of their own, but given the barriers to entry – and what would be a relatively capital

intensive process – we find this scenario highly unlikely. Of course, if each firm continued as a

separate enterprise, Zillow and Trulia would fare even worse. Not only would there be outside

competition from Move, Reology and Redfin, but Zillow and Trulia would have to continue to

compete with each other.

E. Investor recommendations

Zillow and Trulia have the audience, but they won’t be able to monetize, and the audience will

go somewhere else – which is exactly what happened with Realtor.com 10 years ago. In light of

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this, the growth rates projected for both Zillow and Trulia are flat wrong. We expect revenue

growth to remain steady into 2015, but to drop to no more than 30% for Trulia, 15% for Zillow,

and 20% for the combined enterprise13 in mid-2015 as the sweet spot in the market is fully

saturated (again, the sweet spot refers to brokers large enough to buy ads but not too large that

they can bargain for a discount). Couple this with increased competition over this sweet spot by

Newscorp via Move via Realtor.com, and growth should fall into the single digits by 2016.

The merger will go through but instead of the combined entity being able to raise prices to gain a

higher ARPU, the combined firm will continue to see its real ARPU fall as the large brokers

demand discounts. This lack of bargaining power, coupled with Redfin’s possible 2015 IPO and

Realogy’s launch of a competing site, should decimate ARPU in 2016.

The inevitability of slowed growth makes the current non-GAAP valuation, which justifies the

share price, incredibly troubling.

As a result, we look for the shares of Zillow and Trulia, and shares in the eventually combined

firm, to fall substantially. This fall will also be precipitated by changing macro-economic trends

that leave investors betting on safer stocks and bonds as interest rates begin to rise14.

In the near-term (until the end of 2014), we recommend investors short both companies, as we

expect the Street to become much more skeptical of the fundamentals behind Zillow and Trulia.

13
   The growth rate for the combined enterprise factors in our estimated shared customers that Trulia and Zillow
will have, around 50,000 premier agents.
14
   We refer here to what we see as a general overvaluation of tech stocks in this low-rate environment, not the
health of the American housing market. The relationship between Zillow/Trulia’s revenues and the American
housing market is not a strong one, coupled with the fact that the listing-firms’ business models are a much larger
issue for future stock valuation. See, GEEKWIRE, Zillow considered buying Realtor.com, but wanted Trulia because
they’re a brand on the ‘ascendancy’, October 3, 2014.

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For the separate enterprises of Zillow and Trulia we have a price target of $22.00 and $58.00,

respectively.

As the merger nears to a head in 2015, investors should bet that the merger goes through – due to

the entrance of Newscorp – and be short Zillow and long Trulia. As for the combined company,

we recommend a short, with a price target next year of $50-60, given the current macro-

economic environment, and a price target below $30 if rates rise unexpectedly.

As for this market as a whole, we would recommend investors closely watch Realogy and

Redfin, as the real battle to change the market will be played out between brokers who have

websites – brokers without a national site and sites without a brokerage will be left behind.

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F. Appendices

Appendix 1: Zillow Growth Rates

Appendix 2: Trulia Growth Rates

*based on premier-agent saturation in 2015 unless current prices are cut, which will of course cut into
revenues

Appendix 3: Zillow DCF

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Appendix 4: Trulia DCF

Appendix 5: Combined firm growth

Zillow Premier
Subscribers with                      Dec-11   Dec-12   Dec-13   Dec-    Dec-15   Dec-16   Dec-17   Dec-18   Dec-19
                                                                 14
Trulia
Acquisition
Premier Agent                         15799    29473    48314    72471   94212    103634   108815   114256   119969

Subscribers
                                yoy growth     86%      63%      50%     30%      10%      5%       5%       5%

Premier                               $        $        $
                                      254.00   267.00   271.00
Subscriber
Monthly Fee

                                      $        $       $      $       $       $       $       $       $
Yearly Revenue                        36,749  75,900  132,396 195,672 173,930 180,018 198,020 207,921 218,317
(In thousands)
Dollars Per                           2.33    2.58    2.74    2.70    2.00    1.80    1.80    1.80    1.80
Agent (In $
thousands)
* Note that as Premium agent subscribers goes up by 30%, which factors in the customers of Zillow and
Trulia that do, and do not, overlap, ad-dollars per agent begins to drop due to increased competition,
bulk-discounts, and reduced ad-inventory

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Appendix 6: The large brokers wanting discounts make up about 70% of the 500,000 agent-market, as
measured by number of agents:

Top US brokers                                             U.S. Agents
Realogy                                                         170,278
RE/MAX                                                           54,491
Keller Williams                                                  74,470
Berkshire Hathaway HomeServices / Prudential / Real Liv.         55,000
Total                                                           354,239

Appendix 7: The merger premium

Assumptions                                 Zillow                        Trulia
Stock Price                                  $             106.73          $                 46.06
Shares OUS (000's)                                     40,314,000                      36,898,000
Market Capitalization of Equity (mm's)       $    4,302,713,220            $        1,699,521,880
Pre-Deal Net Earnings (mm's)                     (15,200,000.00)                   (46,400,000.00)
Pre-Deal Net EPS                             $            (0.38)           $                (1.26)

M&A                           PREMIUM            Zillow                             Trulia
# Shares in Zebra Holdco for each current share       1.00000                               0.444
Shareholder Value pre-deal                 $ 4,302,713,220                 $       1,699,521,880
Total Value of Zebra Holdco +100m synergies
Total Zebra Holdco Shares OUS
Total Zebra Holdco Shares Owned                 40,314,000.00        71%           16,382,712.00
Post Deal Shareholder Wealth               $ 4,338,973,057.58        71% $         1,763,262,042
Total Zebra Holdco TTM Net Earnings
Total Zebra Holdco EPS
EPS for Zebra Holdco                                     (1.09)                              (1.09)
EPS Equivalent per Legacy Share            $             (1.09)            $                 (0.48)
Pre-Deal EPS                               $             (0.38)            $                 (1.26)
Accretion/Dilution per Legacy Share                      -188%                                 14%

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Appendix 8: Realogy’s Fab-Plus