Description

1. Business Background
2. The Bull Case
3. The Bear Case
4. Valuation
5. Conclusion

Business description

Zillow operates what they call the “largest living database” of homes - an online residential real estate marketplace which has pricing, pictures and other detail for approximately 100 million homes in the United States. The company provides information on properties and mortgages that can help drive transactions by connecting buyers, sellers, renters, landlords, and service providers like brokers and mortgage specialists. The company also provides home value and rental pricing estimates to assist in valuing homes that currently aren’t on the market.

Zillow's business model targets both consumers and real estate agents, but focuses on agents

Zillow intends to gain revenue from virtually every player in the residential real estate ecosystem, either directly or indirectly. The ecosystem consists of homes, agents, consumers, ancillary service providers (e.g., lenders/legal/rental/other services), and advertisers. Zillow revenue comes from:

• Agents - Listing fees, subscriptions and advertising
• Ancillary service providers - Referral fees, advertising
• Advertisers - Advertising

Zillow’s key revenue producing products/services  

Agents and/or brokerages can pay to have their listings appear higher up in the search results, so called "Featured Listings." Featured listings also allow the agents and/or brokerage to post a profile picture of the agents, list the agents contact details, and provide a “contact agent” button. Agents that pay for "Premier Agent" status will have their photos and contact link place at the bottom of the search results.

Company history

Zillow was founded in 2005 by Rich Barton and Lloyd Frink, former Microsoft executives and founders of Microsoft spin-off Expedia. Zillow’s IPO was completed in July 2011 at $20 per share. Several large Venture Capital firms have been involved in the past and continue to be involved today:

• Benchmark Capital
• Richard Barton, Zillow Board Chairman
• William Gurley, Zillow Board member
• Eric Blachford, Zillow Board Member
• Technology Crossover Ventures (TCV)
• Jay Hoag, Zillow Board Member
• PAR Capital Management

Management has recently evolved the Zillow business model from a disintermediation tool (consumer focused) to a agent-empowerment tool

Current capitalization and valuation
Source: CCM analysis, Capital IQ

(1) - CCM estimate – pro-forma share count and cash balance based on Zillow’s 9/5/2012 follow-on offering.
(2) - CCM estimate – reflects adjustments for tech development expenses that are capitalized on Zillow’s filed financial statements
(3) - Estimates reflect sell-side consensus as provided by Capital IQ and is subject to future revision

Sizing the market
Source: Move.com  second quarter 2012 investor presentation

Addressable market is huge
Source: Borrell Associates 2012 Real Estate Outlook, Trulia IPO roadshow presentation

It is widely believed that $5B of the $24B in total advertising dollars is spent directly by transactional (non-rental) agents & brokerages. Approximately $1 trillion of residential real estate transacted every year. Agents commissions are around 5%, or $50 billion. 10% marketing spend = $5 billion. Of the $5 billion of advertising & marketing spend, online is estimated to be $1B and growing at ~20% per annum. Agents and brokerages leverage many tools to create impressions and ultimately generate business. Offline includes signage, print, television, literature/pamphlets. Online includes owned websites, listings on Zillow and other syndication sites, display and banner ads, search results optimization

Platform traffic growing rapidly
Source: Zillow  2011 10-K, Zillow quarterly earning press releases 

• “According to a 2012 survey by The Real Estate Book, a real estate website, 52% of respondents reported using a mobile device to look for homes, with 85% of non-users stating that they would consider using a mobile device for their next search.”
• (Trulia IPO Prospectus, 19 September 2012, p2)
• “Over 50% of our home views now occur by consumers on a mobile device.”
• (Zillow Prospectus, 7 September 2012, p S-4)
• Up from ~ 1/3 of usage
• (Zillow Presentation, March 2012)

Mobile growth rates are 100%+

• MOVE Q2:12
• +200% homes-for-sale viewed
• +300% photos viewed
• +120% mobile connections
• Trulia
• +141% mobile visitors (Q212)

Upselling and continuing revenue

• Rentals - Listing Fees, Renter Pre-Qualification
• Finance / Legal - Mortgage Origination, Refinancing, PMI, Closing
• Other Services - Moving, Renovation, Cleaning, Landscaping, etc…

Big growth expectations
Source: Company IR presentation (March 2012), Capital IQ, CCM analysis 

Some sources indicate that there are 1.8M real estate agents in the US. However, data from The Economist suggests the number of active agents is much less. There were 4.8M annual transactions in the US in 2011. According to The Economist, the average active agent has 7 transaction per year. These numbers imply the number of active agents in the US is about 700 thousand, less than half of the 1.8 million Zillow claims.

There are very few agents who have not been pitched to by Zillow already
Source: Company estimates

I believe that virtually all of the addressable market has been solicited by Zillow and others with these services and most have chosen not to pursue a premium membership.

• I believe most agents do not see enough benefit from a paid account to switch from their free accounts
• Free Account includes:
• Ability to post listings with 5-10 pictures
• Listings end up in search results organically
• Paid Account Includes (For up to $2,400 per year)
• Listings with unlimited pictures and edit ability
• Featured placement of listings, contact information
• Zillow has 409 thousand agents signed up to free accounts (95%) and 23 thousand agents signed up for paid accounts (5%)
• Zillow's 5% conversion to paid accounts is consistent with the 4-6% conversion range for other "freemium" models
• Pandora
• Spotify
• LinkedIn

There are fewer dollars to capture from brokerages/agents than management wants to think
Source: Borrell Associates 2012 Real Estate Outlook; Citi Investment Research; The Economist “American Property” 5 May 2012.

• Total real estate ad spend is expected to decrease from $28.3B in 2011 to $23.7B in 2012, a decline of 15% y/y and 20% decline since $29.5B spent in 2010. Furthermore, survey results indicate brokerages/agents are going to keep ad spend flat. 65% of respondents to a CIty Investment Research survey this year indicated they would keep spending the same when asked if they planned to increase or decrease overall ad spend in the next year.

As a result, there will be less marketing dollars for online

• Even though online ad spend as a share of total ad spend will grow, the total $ value of ad spend will be declining
• I believe $5B current overall ad spend could shrink to $3B

Pressure on commissions will reduce ad spend further

• I believe that disruptive pricing models and the spread of information will lead to a reduction in the average 5-6% commission for real estate transactions over time. 2-3% realtor commissions in the UK indicate where US commissions could end up
• Downward pressure on commissions is in the news
• “Lately that figure [6%] is under attack by buyers and sellers looking to save money in a tough economy, and by an array of alternative real estate business models that offer an à la carte menu of services to clients willing to do some of the work themselves.”  New York Times, January 2011
• “What happened to travel agents, stock brokers and book sellers – the encroachment of the Internet – is beginning to affect real estate agents. And the sacred six percent is under assault from online discounters.” CBS News, February 2009
• I believe a decline in commission percentages will primarily effect buyer’s agents
• Buyer’s agents’ value-add decreases as information availability increases while seller’s agent still generally has to do the same amount of work

• 45% of listings were "featured" in an real urban search. Is having a featured listing valuable to an agent if nearly half of all listings are "featured?"
• 49 featured listings out of 109 results in Gold Coast/River North/River West, 2+ bedroom, $295K - 400K
• 5 of 15 listings in a suburban search were "featured." Does it pay to be "featured" when 15 homes are for sale? Consumers will likely look at all 15 properties anyway
• Upper Arlington, OH, 3+ bed, $245K - 300K

The ROI to agents is an illusion
Source: Industry interviews, Trulia, NAR, US Census

1. As Zillow and the other syndication sites sign up as many agents as possible to their premium services, the conversion rate per agent will decline significantly.
2. Most of the leads syndication sites say they “bring” to the premium agent would have ended up in the agent’s hands through some other traditional means. Thus the syndication sites should only get credit for incremental leads in calculating ROI to the agent. To account for this discount, in the model below I have reduced the 120 leads per agent per year pitched by Zillow to a more realistic 20 leads per agent per year.

Zillow’s Zestimate was attractive in the beginning, gaining Zillow share with page views and uniques, but is now a drag on performance. Speaking with agents and brokerages has led me to belive that Zestimates are not useful, and are potentially harmful. Agents stated that Zestimates are too impercise and people have realized it. Agents dislike Zestimates because they give consumbers false expectations of value, making the agents' job more difficult. Furthermore, Zillow claims it has the “largest living database” of homes, but this should be easy for competitors to replicate over time without a lot of capital commitment because much of Zillow's data is publicly accessible or comes from ListHub. Zestimates have a wide margin for error, leading to levered impact on sellers' return. More than 20% of Zestimates are more than 20% incorrect:

A 10% difference in realized sales price results in a nearly 40% drop in equity value to owner when LTV is 70%. For example, an owner with a $140K mortgage who believes they can sell their a home for $200K would see a 38% decrease in equity value if they sell at a Zestimate which is 10% below $200K (assuming a 5% agent commission).   

Zillow has been keeping inaccurate data on its site
Source: WAV Group “The Accuracy of Real Estate Websites”, October 2012 

• Mostly identical data sources
• Inexpensive data
• Analytics easily replicable
• Large number of uniques can be acquired through marketing spend    

A hot space has invited too many players:

• Realtor.com - Entered 1996
• HouseValues.com - Entered 1999 (Now LEDR)
• Zillow.com - Entered 2005
• Trulia - Entered 2006
• Move.com - Entered 2006

It is difficult to differentiate on websites - they all look similar:

• I invite the reader to go to Zillow.com, Trulia.com, Realtor.com and Homes.com. Finding key points of differentiate is difficult.

It is also difficult to differentiate on features:

• Realtor.com (MOVE) is undergoing a turnaround. It is launching its new website, has long-standing backing by NAR, and possesses the highest-quality listing data (accuracy, refresh rate). Additionally, it is coming out with innovative products (agent-branded app, new Top Producer CRM) and has a new CFO.
• Trulia (TRLA) recently a raised $102 million in an IPO and has more user-generate content, features, and better consumer reviews.
• New entrants are appearing rapidly including Homes.com and a new HouseValues.com website.

Recent traffic data shows that Zillow may be losing some uniques to the competition
Source: Compete.com

Management's focus on uniques overstates the number of people looking to buy a home
Source: Trulia IPO Prospectus, Zillow press releases, NAR, Industry interviews

• Zillow has shaped its listing policy to keep traffic on its site, a big relative difference from competition. Trulia allows agents to provide links to their own site’s listing off of the search results page (SRP), while Zillow does not. Trulia also allows several opportunities to point to agent sites from the property listing page, whereas Zillow offers few.
• Not allowing the agent to promote his/her own page blocks the consumer from accessing better and more complete information about the property they’re interested in.

• From an article in MSN Money earlier this year: “San Diego Realtor Jim Abbott studied three years of his agency's sales data and compared listings that the company didn't share with national sites to those it did. "Time after time, the listings that I did syndication compared with the listings that I didn't had no better outcomes," he says. "In fact, the ones I didn't syndicate often sold faster and closer to the asking price.”

Zillow has done little to mitigate an adversarial relationships with brokerages

• Several realty firms and trade groups have argued publicly against using the site, pulling listings and canceling contracts due to poor quality leads and Google search manipulation (taking organic search results from brokerage-owned websites, and poor/inaccurate information)
• “Before [Zillow] had one agent getting the lead, and now they have three agents getting the lead…Zillow went from being A+ to D- on their lead quality.” (James Sanson, Agent, Sonoran Properties, Blog post, 6/15/2012)
• "Neither you the home seller, nor the potential buyer, is served well by  [Trulia and Zillow].” (David Cooper, CEO, Prudential KC RealtyApril 2012)

Real-estate professionals are banding together to create a non-profit listing site
Source: AG Beat, NAREP website

• National Association of Real Estate Professionals (NAREP) founded October 10, 2012 is a non-profit trade organization designed to create an independent listing database accessible by consumers and with no advertising or “premium” options
• Claims Zillow and other listing syndication sites have diminished credibility and positioning of real estate professionals
• NAREP plans to sign up agent/brokerage members with intent to have all participants shut off all listings to Zillow and other sites once meaningful listing volume is met
• "We'll cut off the supply of MLS listings to the syndication sites" (NAREP website)

The Zillow story has been seen before, with less than stellar results
Source: Capital IQ; Kelly Blue Book,  J.D. Power New Autoshopper.com Study, 200-2008, J.D. Power WSPT 2009-2010

• HouseValues.com IPO'd in 2004 at $500M valuation and was expected to revolutionize lead-gen for agents
• Began acquiring companies to keep up growth pace, but lack of significant market growth led to destruction of value
• Share price declined 81% from $15 2004 IPO price to $2.75 on August 28th 2008, even before the subsequent financial markets meltdown

Analogy with auto websites is not necessarily a positive for Zillow

• Early champions of auto industry ad spend such as Autobytel have not benefited from the steady growth in auto-related internet usage among new-vehicle buyers
• While auto-related internet usage has increased from 54% to 79% from 200 to 2012, the share price of Autobytel, an early champion of auto industry ad spend, has decreased from over $200 to less than $5.
• Early auto-lead companies suffered from the same problems currently effect Zillow: exaggerated ROI and poor lead quality.

Insider selling raises red flags
Source: Capital IQ, SEC Form 4 filings, Zillow 2Q11 earnings call

• BankRate – Personal Finance (home mortgage, credit cards, bank accounts)
• Autobytel – New / OEM Car Sales
• Quinstreet – Online education 

• Connection to user (consumer) is seldom as home purchase/sell transactions occur once every 12-15+ years 
• No opportunity to increase transaction volumes
• Agent population is difficult to work with, yet has inherent information advantage (local knowledge)

Sales & marketing could be a large long-term drag on Zillow
Sources: Company filings, Capital IQ

• Switching costs in the industry are low and agent turnover is high. Contracts with agents/brokerages range from 6 months to 2 years with very easy out clauses. As a result, the company has had to put significant dollars behind sales and marketing and will be forced to continue increasing its sales and marketing commitment to maintain share.
• In 2Q12, y/y increase in sales & marketing (GAAP) was 115.9%, while y/y increases in uniques and premium subscribers were 69.6% and 65.9%, respectively. Zillow may have to continue increasing marketing expense at a rate higher than unique & subscriber growth. 

•  The issues specific to Zillow’s niche (low switching costs, dealing with agent population, etc…) force the company to invest heavily in sales and marketing in order to maintain market share. Heavy inside-sales element means high-turnover sales positions with little ability for leverage with scale or experience.
• Other companies facing such issues have similar sales & marketing expenses as Zillow (44% trailing 10 qaurters average, Non-GAAP, as % of sales): Expedia (41%), Constant Contact (43%), Groupon (67%).  
• Nevertheless, Zillow has a dramatically higher 2013 EV/EBITDA (49.7x) as compared to Expedia (7.9x), Constant Contact (9.4x), Groupon (3.4x)

Valuation of the industry
Sources: Company filings, Capital IQ 

Conclusion

Short-term bear case

• Issues with growing traffic and revenue
• Industry doubting value of service offering, claims of ROI, and Zillow’s overall intentions for the market
• Competition is heating up
• Insider selling raises red flags
• Unrealistic implied industry valuation

• Overestimated Market Opportunity - Fewer agents to sell to than management states. Fewer dollars to capture from agents than management claims. Syndication companies and investment community using incongruent data, fuzzy math that erroneously inflates market size
• Questions about the Business Model - Lead generation model not scalable (heavy sales and marketing spend). Zillow’s technology doesn’t provide superior value (Zestimates are inaccurate)
• Competition is fierce, increasing - Several competitors in the space, many trusted more by agents than Zillow. MLS and other industry resources provide free alternatives to paid syndication sites.

Risks

The big-picture risk is a resurgence in the housing market which could drive up both the number of transactions and the dollar-value of agent's commissions (as housing prices increase). On a more micro-level, Zillow could either come out with new products (e.g., additional mortgage products), or develop a new revenue model (e.g., impressions-based pricing). The risk from mortgage products may be more important in the short run as interest rates are at all-time lows. In the short-term, Zillow may be able to push through pricing increases to agents and brokerages, though I believe the negative reaction from the agents and brokers will put a limit to the size of those increases. There is also an outside chance that better corporate cost control could lead to an earlier path to profitability targets.

Catalyst