• Abstract and Figures
• Public Full-text

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 stone1, 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 GAO believe 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 GAO space. 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 GAO The 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 Justice2 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 GAO commissions 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 GAO Zillow 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.

Load more

  27

Copy Link