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This Highflier Could Soon Come Crashing Back to Earth

David Sterman

This weekend marks the two-year anniversary of the IPO for real estate listing firm Zillow (NASDAQ:Z), which came public on July 19, 2011, at a price of $20 a share. The IPO finished its first trading day near $36 a share, and after some intermittent stumbles, has soared to a recent high above $68. That's a 240% gain in just two years for those lucky enough to buy into this IPO.

Yet, if you own the stock now, it may be time to head for the exits. That's because the current valuation is starting to bear almost no relation to the intrinsic value of this business.

Z Stock Chart

In hindsight, investing in Zillow's IPO should be seen as a no-brainer. The company wisely took advantage of homeowners' desire to have much more information when deciding to buy or rent a home. Real estate brokers were always stingy with such information, a strategy they now should regret as companies like Zillow "democratize" the flow of information.


More importantly, Zillow has managed to become a middleman between potential buyers and real estate brokers, generating solid revenue streams from sales leads that are pushed toward real estate brokers. And management has been busy on the deal front, making six acquisitions in the past few years, and launching a number of ancillary offerings that have created an impressively broad platform.

Moreover, management has hinted at new products that will be rolled out, which is one of the reasons investors are pushing this stock to fresh all-time highs on a daily basis. Yet, this is where things get tricky. Digging through the income statement, two red flags appear. And in next month's quarterly conference call (slated for Aug. 6), those red flags might morph into real trouble for this stock.

For Zillow's management, it's been crucial for the company to be seen as a broad-based platform for growth and not just a one-trick pony for real estate sales leads. That's not a business with a wide moat, in and of itself. Yet, have the company's newer initiatives really gained traction?

As an example, Zillow sought to profit from homebuyers that needed to seek a mortgage. In 2008, the company launched the Mortgage Marketplace, which enables consumers to obtain mortgage loan quotes without revealing personally identifying information. The launch was initially quite successful, as mortgage lenders happily paid Zillow on a per-lead basis.

But this initiative is already slowing. Revenue in the first quarter of 2013 rose just $600,000 sequentially, failing to get a solid lift during a seasonally strong period. How will investors react if this division, which is Zillow's third-largest revenue stream (besides ad displays and Premier Agents' lead referrals), stops growing after this summer's seasonal boost?

But it's the broader company growth rate that should concern investors, especially as it relates to the stock's valuation. Analysts' forecasts reflect an anticipated slowing in the revenue growth rate, and it's a trend that is likely to continue into 2014.

Of even greater concern, Zillow is now aggressively boosting its own marketing costs just to meet the current rates of projected sales growth. In fact, marketing spending is rising so quickly that EBITDA is expected to fall from $25 million in 2012 to $20 million this year. That's not a disastrous drop off, but it's a sure sign that Zillow is suddenly working a lot harder to attract new business. In effect, the "low-hanging fruit" may have already been tapped with Zillow's market opportunity.

What are investors paying for $20 million in EBITDA? Well, Zillow has an enterprise value of $2.2 billion. That's an EV/EBITDA of more than 100!

Of course, investors are looking ahead: Zillow is expected to generate $50 million in EBITDA next year and $65 million in EBITDA by 2015. Still, this company is valued at 34 times projected 2015 EBITDA, on an enterprise value basis. That's twice the 2015 multiple sported by firms such as HomeAway (AWAY) and Move Inc. (MOVE).  

Fair value for this stock, reflecting still solid growth rates in coming years, is closer to 22 times projected 2015 EBITDA, or around $45 a share. That's 32% below current levels.

Rising marketing costs, decelerating top-line growth, disappointing launches for new product lines and staggering valuations make this stock highly vulnerable to any whiff of bad news when Q2 results are announced. Even if Zillow manages to deliver exceptional results, it's hard to see how this nosebleed stock can move any higher. That means Zillow's risk is much greater than the potential reward, which sets the stage for an opportunity to buck the tide and short this stock.

Recommended Trade Setup:

-- Sell Z short at $60 or above
-- Set stop-loss at $70
-- Set initial price target at $45 for a potential 25% gain in six weeks

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