Zillow & Trulia Won't Shake up the American Real Estate Market
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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. University of St Thomas Opus College of Business, 3 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. University of St Thomas Opus College of Business, 4 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 University of St Thomas Opus College of Business, 5 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 University of St Thomas Opus College of Business, 6 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. University of St Thomas Opus College of Business, 7 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.