Author: Barry Randall, Crabtree Asset Management
Covestor model: Crabtree Technology
Some people — mostly realtors — curse Zillow and its infamous "Zestimate" home valuations. But it can't be denied that since the company was founded in 2004, it has quickly earned its leadership of its segment. Moreover, that position has been achieved despite real estate values declining during most of Zillow's existence.
But now, just as many industry observers believe American real estate values have actually bottomed, Zillow's stock price may have topped out.
Zillow reported their second quarter (June) earnings in early August. On paper, the company's financial performance was impressive. Revenue grew 76% year-over-year, driven by 70% growth in the Premier Agents who sign up with Zillow for co-marketing and other specialized services.
On the user side, average monthly unique users grew to 33.5 million during the quarter, a gain of 61% from the second quarter of 2011. And for the first time, more users viewed Zillow's database information via a mobile device than via a desktop. Unlike, say, Facebook (FB) , this switchover to mobile access is not categorically bad for Zillow because the majority of Zillow's revenue is from agents, not advertising.
So Zillow the company is doing great. But Zillow the stock may have just sprung a hole in its roof. In the company's earnings release and on its conference call, Zillow's management offered up the following guidance for its third quarter, ending in September:
"Revenue for the third quarter of 2012 is expected to be in the range of $30.0 to $31.0 million. This represents 60% year-over-year growth at the midpoint of the range over third quarter of 2011 revenue of $19.1 million."
OK, that's fine, and it's consistent with the $30.5 million consensus estimate.
"Adjusted EBITDA for the third quarter of 2012 is expected to be in the range of $4.75 to $5.25 million, representing 16% of revenue at the mid-point of the range, compared to third quarter of 2011 Adjusted EBITDA of $3.7 million, which represented 19% of revenue."
Uhh ... that's not so good.
In fact, that decline in guided EBITDA margin is pretty awful, when placed in context. So what is that context? Gross profit margins. Let me explain.
Zillow's gross profit margin in the second quarter was a whopping 88%. Which means there is huge earnings leverage for every new dollar coming through the door. Sure, Zillow needs to hire more salespeople to support its anticipated 60% revenue growth, but it's not like it has to erect factories and buy huge amounts of raw material. This is a super-powered business model with the profitability of a software company — even better, as their service is delivered over the Internet.
But the company's Q3 guidance is for EBITDA margins to decline, when they should be going up (remember, 60% growth and 88% gross margins = accelerating earnings power). According to one Street analyst, "third-quarter guidance projects increased investments in engineering, advertising and sales force expansion and believes these investments are warranted to protect Zillow's first mover advantage."
Wait a minute, did you say, "protect"? Why does Zillow, growing at 60% need to protect anything? Is Trulia (a close second to Zillow in the online real estate information game) closing in fast? Perhaps. After all, Zillow's revenue growth was 103% in the first quarter and decelerated to 75% in the second. Third-quarter guidance is for 60% year-over-year growth.
After the sell-side analysts crunched the second-quarter numbers and made sense of guidance, the consensus earnings estimate for all of 2012 rose by exactly one penny to $0.29. This makes Zillow's estimated EPS for the next four quarters to be $0.49/share, giving the company a forward P/E valuation of 82.
So let's summarize: Growth decelerating, limited operating leverage, competition a little more aggressive and a premium price.
Again, Zillow the company is doing great. But Zillow the stock is suddenly on the wrong side of the tracks. And my experience as a long-time money manager is that eight out of 10 stocks with this profile underperform. Oh, they might actually go up a little, but they won't go up quite as much as other companies for whom expectations aren't, well, through the roof.
Which is why after digesting the earnings news and analyzing it, we have sold our Zillow position in our Crabtree Technology portfolio .
We'll keep an eye on it though, with fond memories of our time together.