Tuesday, November 06, 2012

Zillow (NYSE:Z): Sometimes It’s Important to Remember These Guys are “Empire Builders”… - PAA Research

Shares of Zillow (NYSE:Z) the online real estate database have been under pressure since late September when Citron Research issued a hit piece on the name calling the business model dysfunctional and advised investors to short the stock. The stock saw another wave of selling last night after the co presented their Q3 results and issued Q4 guidance. To many, below-consensus Q4 numbers appeared to confirm Citron's negative views. Z ended down -20% in after market trading.

Much to my surprise, PAA Research a boutique firm known for their hard hitting negative views is out defending Zillow (NYSE:Z) this morning.

Here's what they have to say:

If you told us heading into the earnings print that Zillow would have added more than 4,000 premier agent subscribers in the third quarter, we almost certainly would have expected Zillow shares to trade higher. Obviously that has not happened and the stock traded off sharply after hours, largely in response to weakness in display ad revenues and disappointing 4Q12 guidance. As long time followers of PAA Research know, we’re not the type of firm that simply espouses the usual “buy the dip” mantra. We view any meaningful reaction in a stock as cause for serious reevaluation of our investment thesis. In our view the circumstances that facilitated the sharp sell-off after hours are as follows:

Zillow completed a secondary offering in early September, including the issuance of roughly 4.0MM primary shares. Growth companies are expected to significantly exceed consensus forecasts following the issuance of stock. Zillow beat numbers handily, but guided lower for 4Q12.

Insiders have continued to sell shares. To be noted, insiders still own more than 30% of the company and the percentage of shares sold has been small, but no one likes looking at form 4 filings every week.

Citron Research issued a “short report” on the company. As a firm that prides itself on short idea generation, we do not take these types of reports lightly. In general we found the report lacking on a number of fronts. For now it appears they’ve been fortunate to be at the “right church and in the wrong pew” as far as their short thesis is concerned. Zillow crushed our estimates for premier agent growth and witnessed solid improvements in ARPU, both of which contradict the principal elements of Citron’s short thesis from what we can see.

Guidance was disappointing and management did a poor job of communicating some of the factors that contributed to the perplexing outlook. Two factors largely contributed to the relatively soft topline guidance: slowing in display ad revenue growth as a result of change in Zillow’s advertising relationship with foreclosure.com and increased transaction and integration costs as a result of two small acquisitions Zillow will complete this quarter. We estimate those two items will reduce Zillow’s EBITDA by more than $2.0 million in 4Q12. Management should have explained these two issues up front rather than having analysts try to “ferret out” their impact.

The question remains: What elements of our thesis have changed here? In the case of Zillow, we continue to be encouraged by robust consumer engagement and increased traction with residential real estate agents. Display revenues were soft in the quarter and are expected to be down sequentially in 4Q12, but that’s not really a principal part of investment thesis on Zillow. The company continues to add tools for residential real estate agents, mortgage brokers/underwriters, and property managers that will increase engagement and customer lifetime value. At the same time, the vibrancy of Zillow’s property database increases with each passing month, which continues to drive higher consumer traffic and engagement. Zillow has established clear mobile leadership and all signs point to the company becoming a preferred marketing partner for agents, mortgage issuers, and other participants in the real estate value chain while establishing itself as the defacto residential real estate search engine for consumers. Zillow management appears focused on building the company for the long haul, which will come at the expense of near term earnings in some cases. They are in short, attempting to build an empire.

In the context of our estimates and the enormous total addressable markets in which the company operates, we think Zillow shares are attractively valued. We anticipate the stock could trade to 35-40x our FY14 EPS estimate within the next 12-months as investors gain greater understanding of the transformational role Zillow can play in the residential real estate market. On a much longer term basis, we anticipate Zillow could generate $1 billion in revenues with EBITDA margins in excess of 40%, which suggests upside in the stock could be far greater than our $50 near term objective.

Notablecalls: The PAA Research piece goes into much more detail (8 pages worth) explaining why the -20% decline in Zillow stock in after hours trading was way overdone. Certainly worth a read, especially if one is short the name.

The co added 4,000 subs which is almost 2x the consensus expectation. Also, the Q4 EBITDA guide miss can be explained by seasonality and the loss of foreclosure.com ad revenues as Zillow launched their own competing service.

Another thing to consider this morning is the fact there are no analyst downgrades in the name. Targets and estimates get lowered but that's about it. Canaccord lowers their target to $45/share (down from $50) noting core business continues to be very strong and is improving etc.

One more thing, you may want to put on your tin foil hat for this: The stocks' 20% decline happened right after the PR where the Q4 guidance miss was disclosed. It appears some players were in a hurry to sell or push the stock down. Yet, during the call the selling subsided as the management started explaining the nature of the guide miss.

So, if one combines all this- the PAA defense, lack of analyst downgrades and the after market trading dynamics, a case for a bounce can be made. Some of the shorts may want to get out here and there may not be enough sellers around. After all, the short interest in the name (vs. float) is gigantic. Everyone and their mother is already short Zillow.

If or when this reverses, I would not be surprised to see $30+ levels in the name today.
Most certainly a controversial name so adjust your risk accordingly. Use a scale-in approach if possible.


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