Zillow (Z) agreed on Monday to acquire fellow real estate listing site Trulia (TRLA) for $3.5 billion in an all stock deal. TRLA shareholders will receive 0.444 shares of Z for each share they hold, which should increase Z’s outstanding shares by about 41%.
The market has reacted enthusiastically to this deal. Z is up roughly 20% since the news of the potential acquisition first broke. TRLA is up 55%, and has a further 10% to go to meet the stated acquisition price.
Most analysts have hailed the deal as one that will give the combined company massive pricing power and make it the dominant player in online real estate listing. However, analysts have overstated the positives and significantly understated the risks from this acquisition.
Both Z and TRLA have had consistently negative free cash flow, which they finance by further diluting their shareholders. Between 2011 and 2013, Z increased its total shares outstanding by ~38%. TRLA increased its shares by 34%. Both companies are aggressively diluting shareholders to fund their operating losses.
Z’s acquisition of TRLA is an acceleration of this trend. This acquisition will dilute the stock by a further 40%, and the combined company should, at least at first, burn even more cash. Both companies are already operating at a loss, and acquisition costs in the first year will use up additional cash. Z appears far from done with losing money and diluting investors.
Why Investors Are Excited
A combined Z and TRLA would have a dominant market share in the online real estate market, up to 71% according to some sources. Already some are predicting that Zillow could become “the Facebook of homes”, a place where every home’s information has to be if it wants to sell.
Investors are also predicting an earlier path to profitability if the companies combine. Management has projected $100 million in cost savings once the acquisition is complete, and increased pricing power is also expected.
Why This Deal is A Hail Mary
Even if this deal works out as analysts hoped, the profit growth expectations implied by Z’s valuation are already tremendous. In order to justify its valuation of $150/share Z must earn pre-tax margins of 20%, equivalent to what it earned in 2011, its most profitable year, and grow revenue by 44% compounded annually for 10 years.
Like many fast-growing internet companies, Z has forgone profits recently in order to achieve revenue growth. In 2013, it spent almost $160 million on the discretionary items “Sales and Marketing” and “Technology and Development”. These two items comprised 80% of revenue.
Compare this to 2011, when Z spent only 60% of revenue on those two items and managed to earn a 20% pre-tax margin. Essentially, Z’s valuation implies that it will be able to absorb TRLA, scale back spending on marketing and development by 25%, and still grow revenues at a rapid clip.
Additionally, there’s good reason to believe that Z won’t be nearly as powerful or profitable after the acquisition as analysts are projecting. The companies have acknowledged that combined they still only account for 4% of U.S. real estate marketing spending, and Citron Research has raised some interesting questions as to whether the combined company would actually gain pricing power.
It’s entirely possible that Z could complete this acquisition, become a dominant force in real estate, and make shareholders lots of money. Just like it’s possible for a quarterback to run around for 15 seconds, launch a 70-yard bomb into the end zone, and win the game. Sometimes it happens. More often, though, something goes wrong. The odds are against Z shareholders on this one.
Sam McBride contributed to this report.
Disclosure: David Trainer and Sam McBride receive no compensation to write about any specific stock, sector, or theme.