Focusing on the Long Term at Zillow

When a stock drops by more than 6% in one day due to a research report, long-term investors need to see if any issues were brought up that change the investment thesis. On Friday, Zillow (NASDAQ: Z  ) plunged nearly $10 at one point on the back of a negative report by Citron Research. In some regards, the situation is even more pressing in a stock such as Zillow, which had gained more than 330% off the bottom prior to the report on Friday.

For investors with a long-term view, these large sell-offs can be great buying opportunities. The real key is in determining whether the Citron report uncovers damaging information, or if it only highlights short-term valuation issues that any investor should already have been concerned about with the stock at $100.

Citron's assertions
The report is an interesting read, but it makes numerous general assertions that any investor should already know. Here were the main concerns:

  • Market share -- Zillow owns just 13.5%. The majority of real estate traffic is dominated by individual realtor sites and local MLS listings.
  • Declining margins -- The report focuses on increased sales and marketing expenses as a percentage of revenue. The number has jumped from nearly 40% in the last quarter of 2012 all the way to 70% in the second quarter of 2013. The vast majority of the $13 million increase was due to higher stock-based compensation expenses.
  • Insiders selling -- Insiders have sold shares multiple times, including approximately 2.5 million shares during the recent secondary offering at $82.

The report fails to compare Zillow to LinkedIn (NYSE: LNKD  ) -- a company to which Zillow's CEO likes to draw comparisons -- at a comparable time in its growth, or that the stock-based compensation part of the sales and marketing expense jumped to $7.8 million during its second quarter. LinkedIn has surpassed a revenue run rate of $1 billion and has obtained a dominant position in the market. Not to mention, insider sales aren't necessarily a sign that insiders see bleak long-term prospects.

Best part of the report
The most encouraging part of the report has to be the claim that having only 13.5% of the market is a negative for Zillow. In fact, the limited market share actually makes this story more bullish. As more realtors and consumers make real-estate decisions in the digital age, at least one company, if not more, will prosper handsomely. This relatively small share of the market is what pushes Zillow management to scale sales and marketing expenses in order to capture more. The goal is to become the destination site, and that won't occur with only 13% market share.

Zillow competes against Trulia (NYSE: TRLA  ) and more established players, such as Move (NASDAQ: MOVE  ) , which operates the official website of the National Association of Realtors. Trulia had nearly 35 million monthly unique visitors during Q2 and more than 32,000 subscribers. These subscribers spent an average of $194 a month that could have been spent on Zillow.

Move generated more than $44 million in the consumer advertising sector and attracted nearly 29 million average monthly unique users during Q2. At quarterly revenue of $57.5 million, Move is actually slightly larger than Zillow.

In comparison to these two competitors, Zillow has 61 million monthly unique users and a total of 38,807 subscribers in its Premier Agent plan. The company has roughly an equal amount of users to the combined Move and Truila -- a sign that users don't find all they need on Zillow or necessarily prefer those other sites.

Comparable opportunity
The Citron report mentions that the CEO of Zillow likes to compare its potential to that of LinkedIn, which has created the largest professional network on the Internet and now has revenue of more than $1 billion. LinkedIn shares have soared due to the leverage produced by the model. During the second quarter of 2013, revenue surged 59%, but adjusted net income increased nearly 150%. LinkedIn has 238 million users -- 37% more than last year. The stock is now worth $27 billion, or nearly 10 times the current valuation of Zillow. It is clear that the real estate market could use a destination site similar to what LinkedIn has become for professional networking.

Bottom line
The concerns brought up by Citron are worth researching by long-term investors. The question investors need to decide is whether Zillow will be the company to consolidate the real estate industry in the digital age. The questions regarding high expenses and lower margins are a major concern, but the company needs to grow its users in order to consolidate the industry. Investors should hope this negative report pushes the stock lower so long-term positions can be established at lower levels.

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Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On September 23, 2013, at 6:11 PM, bearsnsox wrote:

    lol Zillow's pump and dump machine to the rescue, Motley Fool was probably tasked to put out 20 new PRO zillow articles due to someone actually posting the truth about Zillow, Citron had it all correct, their spending is out of control, they keep printing themselves stock, aka money because they sell it all (the insiders that is) and they have rewarded themselves MORE THAN the company has actually made!!

    zillow is nothing more than a call center that cold calls agents to get them to sign up, now that they are being called out on it, they are jumping into the rentals market for the steady income

    but as their losses get greater that will not be enough to bridge the gap as the real estate market declines due to the end of fed bond buying

    enjoy the ride down, or as the pump machine MF says, GREAT OPPORTUNITY TO BUY haha

    please be sure to read the motlefy fool disclosure, its a financial website THAT OWNS A STOCK, no idea how thats even legal, but yah please keep that in mind

  • Report this Comment On September 26, 2013, at 9:10 PM, somethingnew wrote:

    I don't own Zillow stock but if I did the thing I would be most concerned about with this report isn't what's in the report rather that it's coming from Citron. Citron is not really the most ethical short seller out there in my opinion but they have enough clout to get people to believe what they have to say whether it's true or not. Short sellers nowadays aren't exactly the Einsteins they were 20 years ago when you had to have intellectual capability to be one. Now all you have to have is a following and a posting platform on the internet. Hence why you have a lot of the new breed of short sellers sellers getting killed on TSLA and other high fliers.

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