Source: Zillow

Those prescient investors who shorted Zillow (NASDAQ:Z)(NASDAQ:ZG) near its highs around $50 (split-adjusted) per share are now sitting on hefty profits. Yet even at current prices, with the stock's value cut in half and trading near the lows of the year, about 20% of Zillow's shares are still being sold short. I think these short sellers are playing with fire, and could be setting themselves up for large losses.

Open-ended growth
As the leading online real estate market place, Zillow is well positioned to profit from the migration of marketing dollars to the Internet. As consumers continue to flock to Zillow's website and apps for their real estate information needs, agents, mortgage brokers, contractors, and other real estate professionals are showing a willingness to pay increasing sums to reach them. It's a classic network effect, one that should steadily widen Zillow's competitive moat as more users join its platform in the years ahead.

Yet although it's the industry leader, Zillow currently has a small -- but growing -- share of this massive market. Even after recently acquiring its closest competitor, Trulia, the combined company still only accounts for about 4% of the $12 billion that real estate agents spend on advertising every year. But with more and more home buyers turning to the Internet to find their ideal property -- the National Association of Realtors places the figure at about 40% -- up from just 11% in 2003 -- Zillow is poised to steadily take share in the years ahead.

That should lead to strong increases in revenue, and thanks to Zillow's highly scalable model, profits should eventually grow at an even more rapid rate. Analysts certainly expect this to be the case, as they're projecting that Zillow's earnings will explode higher at a greater than 40% annualized rate over the next half decade.

It's this type of exponential growth that can lead to multi-bagger stock returns -- and painful losses for short-sellers.

What's different now?
Astute investors may be thinking that much of this was true months ago, and it hasn't stopped Zillow's share price from getting hammered. I won't argue with that, and I'm not saying that Zillow's share price can't continue to head lower in the months ahead. My point is simply that with Zillow's share price now down more than 50% from the highs it reached when the Trulia deal was first announced in July of last year, the risk-reward situation has changed dramatically -- and it's now a much more dangerous time to short the stock.

Many of the catalysts for Zillow's lower share price -- namely the end of its long-standing direct MLS listings agreement with ListHub, the sudden departure of its CFO, and the risks relating to the integration of Trulia -- are now priced into Zillow's stock. By no means have these risks been completely eliminated, but Zillow has already moved to rectify all of these issues.

The company quickly filled its vacant CFO position by promoting chief operating officer Kathleen Philips, an experienced and accomplished executive that should bring stability to the position.

Zillow is also rapidly establishing partnerships with a growing number of direct MLS listing feeds. CEO Spencer Rascoff had this to say on the topic during Zillow's most recent earnings call:

[P]erhaps the most tangible benefit from our massive scale so far was our seamless transition to direct listing feeds in April. MLSs, brokerages and agents understood that Zillow Group offers access to the largest consumer home shopping audience, and they signed up to add listings at an unprecedented rate. We now receive significantly more high-quality listings directly from MLSs than we did when a third-party vendor provided us with MLS listings. And we now have more than 300 MLSs sending us data directly, having added 81 new MLS partnerships in just the last three months alone.

Most importantly, the integration of Trulia is progressing ahead of schedule, which Rascoff also highlighted on the call:

Already, we've fully integrated our rentals, mortgages, display and back of the house operations with Trulia. In fact, we've now moved up the timeline to integrate our agent advertising business by several months, expected to complete this by the end of the third quarter.

Once Trulia is fully integrated, we'll begin to see the true earnings power of the combined company, which I believe short-sellers are severely underestimating -- to their own detriment.