Navigating Muddy Waters: The Future of Zillow and Trulia

Transcription

1 Navigating Muddy Waters: The Future of Zillow and Trulia Meagan Braun Whitney Hales Nuan He Monterey Institue of International Studies The Economist Case Study Challenge November 2014

2 1 Table of Contents Introduction... 2 Independent and Combined Firm Valuations... 3 The Online Real Estate Industry... 6 Standalone Scenarios... 9 Investment Decisions Conclusion Appendix Appendix A: A1: Explanation of separate firm valuation process and findings A2: Cash Flow after Tax methodology: Appendix B: Explanation of Valuation of Synergies Appendix C: Explanation of Different Scenarios for Standalone Companies Alternative 1: High Risk Alternative 2: Low Growth Alternative 3: Negative Stable Growth Notes and Bibliography... 27

3 2 Introduction On July 28, 2014, online real estate media company Zillow announced its plan to acquire its competitor Trulia. The deal is expected to close in early 2015 pending regulatory approval. In an all-stock transaction, each Trulia share will be exchanged for shares of Zillow and each Zillow share will receive one share of the merged company. i This exchange results in Trulia shareholders accounting for 33% of the new company and Zillow shareholders accounting for 67%. The pending merger raises questions about the future of the combined company and the entire industry. Real estate advertising is an estimated $12 billion industry. ii While Zillow and Trulia have grown rapidly since 2005, they still only capture 4% of this spending. These sites, termed syndicators, aggregate data from online databases and Multiple Listing Servers (MLS); provide real estate estimates; and allow realtors to post listings. While individuals browse the sites for free, realtors pay to associate their companies with the listings. The sites entice realtors with large monthly viewership. In September 2014, Trulia captured 55 million unique visitors and Zillow captured 82.8 million. Despite huge growth in viewership, both companies are currently operating at a loss. We value the independent companies and the synergies of the combined firm to provide a basis for comparison with the current market values of the firms. This allows us to assess the terms of the deal and decide which company emerges as the winner. We also predict the futures of the standalone companies, the combined firm, and the industry as a whole. We conclude by recommending stock trades to be made around the transaction.

4 3 Independent and Combined Firm Valuations In mergers and acquisitions, one firm generally benefits more than the other. iii To determine which company benefits more, we must value each firm individually. We used discounted cash flows to determine the equity value of each firm. Appendix A describes our methodology. We found share prices of $96.74 for Zillow and $57.78 for Trulia. In October 2014 Zillow traded at an average of $107.56, while Trulia traded at $ Thus, Zillow is currently overvalued by the market, while Trulia is undervalued. Figure 1: Undervalued or Overvalued? $ $ $80.00 $60.00 $40.00 Fundamental Value October 2014 Stock Price $20.00 $0.00 Trulia Zillow Appendix B describes our valuation of the combined firm with and without synergies. Table 1 below highlights the results. We found the value of synergies to be $1.038 billion.

5 4 Table 1: Value of Combined Firm Equity Value Stock Price Without Synergy $6.040 billion $ With Synergy $7.075 billion $ Synergy Value $1.038 billion $18.31 When talks of the merger surfaced in July, both companies stock prices increased, peaking on July 25. At that time, the fixed exchange ratio represented a 25% premium for Trulia shareholders, which aligns with average control premiums in iv Historically, the ratio of Trulia s share price to Zillow s share price averages However, since the announcement, both companies stock prices have been decreasing. Zillow s stock price has been decreasing at a faster rate, resulting in a diminishing premium for Trulia. In October, the premium averaged only 5.57%, significantly lower than the original 25%. Figure 2 illustrates the historic ratio of the companies stocks and the premium that Trulia receives at different stock prices of Zillow. Table 2 shows the stock prices and premiums at several points in time. As the ratio of Trulia to Zillow stock price approaches 0.444, the premium continues to disappear, completely vanishing when it exceeds this point.

6 5 Figure 2: Ratio of Trulia to Zillow Share Price Ratio of Trulia Share Price to Zillow Share Price Ratio Historic Ratio Average Fixed Deal Ratio Date Table 2: Trulia s Diminishing Premium Fundamental Stock Price Value July 25, 2014 October 2014 avg. Trulia $57.78 $56.35 $45.30 Zillow $96.74 $ $ What Trulia is getting $42.95 $70.53 $47.82 Premium % 25.17% 5.57% Amount of premium -$553,280,000 $529,199,000 $93,310,000 Given the companies volatile stock performance, the fixed exchange rate is an inappropriate deal structure. A combination cash/stock deal would ensure an appropriate fixed control premium and greater security for Trulia shareholders. Given the lack of consideration for Trulia s premium, accusations have been leveled against Trulia s Board of Directors, claiming that they did not fulfill their fiduciary responsibilities. v Trulia s Board did not put the firm up for auction, or even solicit other bids, both of which could have resulted in a higher premium. However, the Board is unlikely to be held liable due to the 25% premium on the date of announcement. Unless it is found that the Board acted

7 6 with gross negligence, i.e. they categorically did not consider the selling price, Trulia shareholders will obtain no recourse. vi Considering the deal structure and the firm values, Zillow emerges as the clear winner. Not only is Trulia undervalued in the market, meaning that Zillow is acquiring it for less than it is worth, but Trulia s premium is also less than the synergy value. Trulia s premium, based on a exchange ratio, shrinks as the price of Zillow s stock falls. Thus, Zillow gets the full value of potential synergies while paying a shrinking premium. The Online Real Estate Industry Online media companies often cite the number of users as a key performance indicator. However, revenues for Zillow and Trulia depend upon attracting realtors and brokers. While the sites must attract enough viewers to entice realtors to pay for listings, there is a greater emphasis on attracting viewers than advertisers. Zillow CEO Spencer Rascoff addresses this disconnect, claiming that the advertising dollars will follow the audience. vii However, there is much reason to doubt his assertion. Many of Zillow s viewers are idle users with little interest in buying or selling a house anytime soon. As few as 3.8 million of its 82 million monthly visitors are actively seeking mortgages in the next three months. viii The National Association of Realtors reports that leads from syndicator sites produce less than 10% of property buyers. ix These figures are indicative of broader macroeconomic trends: decreasing homeownership rates amongst Millennials and Generation X-ers. The number of millennials obtaining mortgages from was half that of Generation X-ers a decade prior. x Trulia also reports a 5% decrease in the homeownership rates in year olds. xi As these two

8 7 constituencies form the bulk of Trulia and Zillow s viewers, this trend is particularly troubling. If the sites cannot provide valuable leads to realtors, realtors will fail to see the value in paying for the sites, thus disrupting the companies revenue streams. Another factor contributing to realtor dissatisfaction is syndicator sites lack of accountability for data accuracy. These sites are not subject to the same legal requirements for data accuracy as MLS providers, and consequently, the quality suffers. In a 2011 study, Trulia found that 69% of errors in online real estate listings came directly from third-party syndication of MLS sources. Of 1.2 million listings, 10% contained errors: 51% of errors were in price, 41% were in property status, and 8% were in both. xii In addition, the sites overinflate inventory by listing redundant properties. In San Diego, Abbott Realty Group estimates that Zillow overstates available inventory by 300%. xiii RealtyV2 reached a similar conclusion by comparing Zillow s listings with that of local MLS providers. In the same time period and zip code, Zillow listed nearly twice compared to MLS. xiv Zillow s Zestimates are equally sporadic: only 50% of Zestimates are within 5% of the actual sale price. xv These inaccuracies lead to viewer confusion and realtor frustration. Jim Abbott, President of Abbott Realty Group, suggests that syndicator sites are failed approaches to property marketing which frustrate home buyers, hurt home sellers, and bring little value to brokers and agents who own the listings. xvi Due to the lack of profitable sales leads and the detrimental effects of inaccurate listings, many realtors have begun to withdraw from Zillow and Trulia. In January 2012, Abbott announced that his company would remove all current listings and no longer post properties on syndicator sites. Since then, a multitude of realtors and brokerages have

9 8 withdrawn. Crye-Leike, one of the top five brokers in the nation, reported no negative impact of market share, days-on-the-market, or sales after pulling all listings from Zillow. xvii Realogy, another top-ranked firm, reported that leads from their company website have viewership growth rates outpacing those of syndicator sites and they convert to sales three times as often. xviii Bob Peltier, President of Edina Realty, summarizes his firm s position after disassociating from syndicators: "The inaccuracies we've seen on third-party aggregator sites give us cause for alarm, and the reality is that we are no longer willing to surrender our business or the consumer's real estate experience to third party aggregators." xix Syndicator sites clearly do not provide the benefits to realtors that they claim. On the contrary, they often damage realtors sales prospects. Some even argue that third-party syndicators are fundamentally unnecessary. Virtually all realtors and brokers have their own websites that link directly to the MLS feeds, eliminating the need for third-party sites. xx Rascoff frequently cites the 4% market penetration of the two companies into real estate advertising as an opportunity for growth. However, of 500,000 active realtors in the U.S., less than 15% generate enough business to justify paying syndicator sites advertising fees. xxi In fact, many realtors report that they cannot afford the monthly fees for Zillow and Trulia - $320 and $206, respectively. xxii Zillow currently reports 55,000 agents advertising on the site, and Trulia reports 70,000. xxiii If only 15% of realtors can afford to pay for the sites, the combined companies may have already saturated the market. Not only is there little room left for growth, but realtors have begun moving in the opposite direction. The trend of realtor withdrawal foreshadows an ominous future for Zillow and Trulia. As realtors disappear, so does revenue. For firms that have yet to

10 9 achieve consistent profits, the ability to attract paying customers will only become more difficult. Standalone Scenarios To account for industry trends, we adjusted our standalone firm valuations. Our first scenario uses a high risk premium, corresponding to the risk of the firms experiencing slower growth than assigned in the fundamental valuation. The firms may find it difficult to continue attracting high numbers of advertisers, given the trend of realtor withdrawal. The second scenario uses a low growth rate, again corresponding to the difficulty in attracting advertisers. xxiv Our final scenario incorporates a negative growth rate in the terminal year, corresponding to an ultimate decline in the industry. The assumptions and growth rates used for each scenario are described in Appendix C. The stock price projections for each scenario are shown in Figure 3 below. Figure 3: Standalone Valuations $ $ Share Price $80.00 $60.00 $40.00 $20.00 Baseline High Risk Low Growth Negative Stable Growth $0.00 Trulia Zillow

11 10 For both companies, all three alternatives significantly lower firm value and stock prices. If we expect any of these scenarios to occur, it means that both firms are severely overvalued in the market. These scenarios are useful to assess the sensitivity of the firms valuations to several variables. Both firms are most sensitive to an increase in risk premium. Zillow and Trulia s share prices fell 65% when incorporating a 5% risk premium. Likewise, decreasing the growth rates caused the shares prices to drop 34% for Zillow and 54% for Trulia. Since we expect to see decreased interest from realtors and advertisers, all of our scenarios show declining stock prices. We do not expect the future to conform to a single scenario; rather, it will lie somewhere along the spectrum of values. As the companies face increased difficulty in attracting realtors, the firm value will move along the spectrum, from our fundamental value to lower values of the three alternatives. Investment Decisions Before it can attract investors, Zillow-Trulia must address its lack of profitability, ensure data accuracy, and adapt its revenue streams to survive realtor withdrawal. First, the combined company must achieve the anticipated cost savings from the merger. These savings will increase operating efficiencies and allow the combined company to obtain consistent profits. Next, Zillow-Trulia must ensure the accuracy of its listings to secure the loyalty of viewers and realtors. Otherwise, realtors and advertising revenue will disappear. Finally, the combined company must adapt its revenue streams to guarantee financial sustainability in the long-run. The companies currently charge rates that only

12 11 15% of realtors can afford; they cannot risk losing customers by increasing fees. Nor can they begin charging viewers without seeing sharp drop-offs in viewership. xxv In order to ensure long-term viability of the company s revenues, we foresee two alternatives. First, Zillow-Trulia could lower its advertising fees. This would allow them to attract more realtors, further penetrate the market, and even decrease concerns about data accuracy as the number of realtor-provided postings (rather than third-party sourced information) increases. Alternatively, the company could completely stop charging realtors and target other companies for advertising instead. This would safeguard the companies from the threat of realtor withdrawal. With no fee, there would be little downside to realtors posting on the sites. This too, would improve data accuracy. The company could then focus on attracting home furnishing, moving services, or other related companies to advertise on the site in a model similar to Facebook s. Fundamentally, the question is, can Zillow-Trulia accomplish these tasks? Only if the combined company can capture expected cost savings, improve data accuracy, and shift its revenue streams, would we recommend that investors purchase the stock. However, we do not believe that these conditions can be met. Throughout the merger conversations, neither company even addressed data accuracy concerns, let alone devised a strategy to resolve the issue. xxvi Additionally, completely overhauling the existing revenue structure would require a costly shift in sales and marketing strategies. While synergistic cost savings may be realized, they are unlikely to be large enough to offset lost revenue from realtor withdrawal. Given our pessimistic outlook of the industry and our valuations, we recommend that all shareholders sell. We valued the combined firm with synergy at $ per

13 12 share. However, potential synergies are predicated on a growing online real estate sector. Our analysis suggests that the industry faces a pessimistic future. Market prices of both companies have fallen by approximately 30%, showing that the market concurs. In addition, short interest in Zillow has spiked. As of November 3, 2014, 42.68% of Zillow s float is shorted. xxvii Investors with greater risk appetites may execute profitable trades by shorting Zillow. Generally, we recommend selling and exiting the online real estate syndicator sector entirely. Recent transactions by Zillow insiders seem to support this strategy. Despite rhetoric describing the opportunities for Zillow to acquire greater market share and increase earnings, Rascoff has been selling large amounts of Zillow shares in the past few months. Since the merger was announced, Rascoff has sold more than $11 million of Zillow stock on top of additional offloading since the beginning of the year. Similarly, Trulia insiders have unloaded $28 million since the January xxviii These actions contradict both companies belief in future prosperity of the combined firm. If they claim that it is such a great deal, why are insiders dropping stocks so rapidly? This pattern suggests that insiders already see the ominous future of the industry and are jumping ship while they can. Conclusion What distinguishes Zillow-Trulia in the merger marketplace? Red flags seem to abound in this deal. Although historically acquirers stocks fall following merger announcements, the current M&A environment shows acquirers stocks rising. This is consistent with the low interest rate environment. xxix As noted, Zillow and Trulia prices

14 13 have both been falling. The segment that Zillow and Trulia operate in is not akin to social media companies and has a murky future. There has been significant insider selling by executives of both companies. Troublingly, the Trulia Board never sought out other bidders, and the Trulia premium has eroded from the outset. It seems that there are governance issues on both sides of the deal, from heavy insider selling to issues of board negligence. Coupled with our projections for the industry, we foresee a multitude of problems attached to the deal. We do not believe that this merger will be valueenhancing.

15 14 Appendix Appendix A: A1: Explanation of separate firm valuation process and findings To determine the fundamental value of each firm individually (Zillow and Trulia), we utilized a nine-year, three-stage growth, Discounted Cash Flow Model plus the value of the terminal year. We projected the Future Free Cash Flows (FFCF) until year 2022 and discounted each to calculate the Present Value of the FFCF. In addition we calculated the FFCF for the terminal year (2023) with a separate stable growth rate. The free cash flow values were determined by first calculating the Earnings Before Interest and Taxes (EBIT), applying the corporate tax rate of 35%, then adding amortization from R&D expenses and amortization from depreciation expenses, subtracting capital expenditure and subtracting the respective year s Net Working Capital. Free Cash Flows = EBIT Tax + Amortization from R&D + Depreciation Capital Expenditures Net Working Capital By combining the PV of the discounted cash flows with the PV of the Horizon value, we determined the firm/enterprise value of each company. With the enterprise value, we then determined the firm equity value by subtracting the debt value from and adding the cash back to the enterprise value. Enterprise Value = PV of Future Cash Flows + Horizon Value Horizon Value = PV of terminal year cash flow Cost of Capital k StableGrowth Rate (g) Equity Value = Enterprise Value Debt Value + Cash Due to significant insider selling, we thought it necessary to separate the value of the options outstanding from the total equity value to determine the true equity value of the firm. After subtracting the value of the options outstanding (Market price per option times Number of options outstanding) from the equity value, we then divided our new equity value by the total number of shares outstanding to determine the true stock price for each firm. We based our value for the number of shares outstanding from that reported by Yahoo Finance. A2: Cash Flow after Tax methodology: In our Cash Flow after tax methodology we calculated revenues (sales) on a 3-stage growth model with a 3-year high growth rate period, a 3-year middle growth rate period, and a 3-year relatively low growth rate period. These rates were determined by assessing

16 15 analysts estimates and comparable companies past performances, namely Yelp, LinkedIn, Twitter, Facebook, Shutterfly, and Google. The terminal year growth rate used was the long-term US GDP growth rate of 1.75%, forecasted by the OECD. Table 1. Forecast of U.S. GDP growth rate 4.00% GDP Growth Rate of U.S. 2.00% 0.00% GDP Growth Rate Table 2. Growth rate of Revenues Year Growth rate Zillow 70.00% 55.00% 55.00% 30.00% Trulia 85.00% 70.00% 60.00% 35.00% % 30.00% 20% 10% 10% 1.75% 35.00% 35.00% 20% 15% 15% 1.75% Trulia was given a higher growth rate based on the historical trend. The Property Plant and Equipment (PPE) was calculated using a fixed ratio of PPE/Sales determined by taking the average of the past 3 years PPE/Sales ratio. The Net Working Capital and depreciation were calculated using the same methodology capturing the past- 3 year average for NWC/Sales and Depreciation/Sales, respectively. The EBIT was calculated using a fixed ratio of EBIT/Sales derived from the average of the past 3 years performance. The EBIT used differed from the EBIT reported in the companies Income Statements termed Operating Loss due to two adjustments. We expect positive net income to be achieved in the future. We adjusted EBIT by capitalizing the R&D expense and converting to capital expenses and by including the operating lease commitments as financial expenses, rather than operating expenses, and converting them to debt. Final Adjusted EBIT = Net Operating Income + R&D Accumulated Amortization + (PreTax Cost of Debt PV of Operating Leases) We incorporated Lease adjustment into (EBIT*/Sales) ratio, by: EBIT = Net Operating Income + R&D + (Pretax Cost of Debt PV of Operating Leases)

17 16 When data gaps surfaced, we used 80% of the previous year s leasing adjustments compared to EBIT as an approximate. Amortization should not adjust taxes because capitalizing R&D does not affect taxes. The R&D operating expense was capitalized because R&D can be considered more of an asset (or an investment), for returns in the future, rather than an operating expense. Amortization of R&D was calculated on a 3-year schedule for the present year using the current industry average. The difference between the originally reported R&D total and the calculated amortization for that year was then added back to the capital expenditure total. Future R&D was calculated using an R&D/Sales ratio schedule derived from comparable industry competitors. Table 3. R&D/ Sales Schedule Year R&D/Sales for Zillow 24.0% 24.0% 24.0% 24.0% 22.0% R&D/Sales for Trulia 24.5% 24.5% 24.5% 24.5% 22.5% % 22.0% 20.0% 20.0% 20.0% 17.0% 22.5% 22.5% 20.0% 20.0% 20.0% 17.0% We gave Trulia a relatively higher R&D/ Sales ratio based on historical trend. This is also consistent with its high growth rate. For the calculation of taxes, we considered the past year s accumulated loss, which were calculated based on the EBIT/Sales ratio (not adjusted by lease), and we subtracted R&D out again to get the EBIT as the tax base. The Change in Capital Expenditure was calculated by taking the difference of PPE in the present year from the previous year. The difference between R&D and the accumulated amortization was added back to the EBIT. The Increase in NWC was calculated from the difference in NWC of the present year from the previous year. The discount rate was calculated using the Weighted Average Cost of Capital (WACC) formula. We used the current market cap as Equity, and book value of debt (adjusted by adding the converted lease commitments) as Debt. Cost of Capital = E V Cost of Equity + 1 t D Cost of Debt V Cost of Equity = Risk free rate + unlevered beta market risk premium

18 17 We chose to use the 3-month government bond rates (virtually zero) as the risk free rate, and 5% as the market risk premium as suggested by Dr. Damodaran and other Economists for the current market. We compared Beta estimates of each firm from different financial websites, and choose the Beta listed on Zack s Investment Research as it matched with Yahoo Finance s estimate of Beta. We then walked down the Beta by 0.1 over 10 years in 3 stages, consistent with our growth stage schedule. We calculated unlevered beta using the formula: Unlevered Beta = Beta (1 + 1 t D V ) For the Cost of Debt we used the interest rate listed in the two companies financial reports, given as 2.75%. Table 4. Beta Stage 1 Stage 2 Stage 3 Stable Stage Zillow Levered Beta Zillow Unlevered Beta Trulia Levered Beta Trulia Unlevered Beta Table 5. Cost of Capital Zillow 6.25% 6.09% 5.92% 5.76% Trulia 7.09% 6.96% 6.82% 6.69% Table 6. Zillow Fundamental Value VALUATION Year Sales 197, , , ,823 PPE 27,408 44,015 68, ,747 NWC 10,510 17,928 27,788 43,072 Depreciation 23,254 38,102 59,058 91,540 EBIT* 32,957 77, , , Amortization 17,136 29,752 51,903 84,675 Taxes Depreciation 38,102 59,058 91,540

19 18 Change in CAPEX 67,454 97, ,486 Increase in NWC 7,418 9,860 15,283 FCF 11,104 20,382 31, Discounted FCFstage1 54,783 Discounted FCFstage2 344,080 Discounted FCFstage3 598,896 Sum of 9-year 997,759 Horizon Value 4,127,145 Enterprise Value 5,124,903 Debt 51,204 Cash 201,760 Equity 5,275,459 Number of Shares 40,120,000 Share Price not considering exec ops $ option outstanding $3,881,172, Considering exec ops $96.74 $1,394,287, Actual Price of 10/17/2014 $105.15

20 19 Table 7. Zillow Fundamental Value Continued ,048,870 1,363,531 1,772,590 2,127,109 2,339,819 2,573,801 2,618, , , , , , , ,239 55,993 72,791 94, , , , , , , , , , , , , , , , , , , , , , , , , , ,166 18,095 19,905 47, , , , , , , , , , , , , ,642 (18,275) 12,921 16,798 21,837 18,926 11,355 12,491 2,405 86, , , , , , , , , , , , ,313 Table 8: Trulia Fundamental Value VALUATION ,805 Year Sales 143, , , , ,373 PPE 22,289 35,714 60,713 97, ,140 NWC 8,679 18,080 30,735 49,176 66,388 Depreciation 12,211 17,915 30,455 48,729 65,784 EBIT* 11,020 42, , , , Amortization 14,551 23,154 39,985 70, ,695 Taxes Depreciation 17,915 30,455 48,729 65,784 Change in CAPEX 49,832 55,416 95, , ,988 Increase in NWC 3,109 9,401 12,656 18,441 17,212 FCF (27,581) (45,741) (67,806) (49,148)

21 20 Discounted FCFstage1 (120,838) Discounted FCFstage2 (144,768) Discounted FCFstage3 (6,706) Sum of 9-year (272,312) Horizon Value 2,805,776 Enterprise Value 2,533,463 Debt 230,135 Cash 225,597 Equity 2,528,925 37,310,00 Number of Shares 0 Share Price not considering exec ops $67.78 option outstanding $2,155,82 5, ,099,851 Considering exec ops $57.78 Actual Share Price $43.83 Table 9: Trulia Fundamental Value Continued ,318,104 1,779,440 2,135,328 2,455,627 2,823,971 2,873, , , , , , ,935 89, , , , , ,375 88, , , , , , , , , , , , , , , , , , , , , , , , , , , , ,746 (27,948) 23,236 31,368 24,198 21,779 25,045 3,360 (66,350) (89,573) - - (14,105) 1,779 2, , ,644,717.64

22 21 Appendix B: Explanation of Valuation of Synergies According to Aswath Damodaran, synergy is the additional value that is generated by combining two firms, creating opportunities that would not have been available to these firms operating independently. xxx Our valuation of synergies is based on this theory. Zillow s acquisition of Trulia is a horizontal merger with potential synergies falling under two main branches: operating synergies and financial synergies. Operating synergies allow the firm to increase its operating income by using existing assets. There are four types of operating synergies: economies of scale, greater pricing power, combination of functional strengths, and higher growth rates. Economies of scale allow the combined firm to become more cost-efficient and profitable. Greater pricing power from reduced competition and higher market share results in higher margins and thus, higher operating income. Combining of functional strengths across the businesses can also increase margins and operating income. Lastly, higher growth from increased brand recognition and an increased customer base can increase the combined firm s profit. xxxi Potential financial synergies can be gained from higher cash flows or a lower cost of capital. Financial synergies include diversification, cash slack, tax benefits, and debt capacity. In some circumstances, an acquiring firm can reduce its risk and create wealth for shareholders by diversifying its holdings. Cash slack results in financial synergies wherein an acquiring firm has excess cash that can be put towards viable projects that the target firm was unable to undertake due to insufficient capital. Tax benefits may occur if the combined taxes paid by the merged firm are lower than the taxes paid by the individual firms. Finally, combining two firms with a low debt capacity may sometimes increase the debt capacity of the resulting firm. xxxii In order to determine the value of synergies present in the combined firm, we took the difference of the combined firm with synergies and the combined firms without synergies. To calculate the value of the combined firms with no synergies, we simply added the standalone values of the firms from our fundamental valuations. The value of Zillow s and Trulia s equities were added together and divided by the sum of their outstanding shares. Since Zillow shareholders are receiving a one-for-one exchange, Zillow s shares outstanding were not adjusted. Trulia shareholders, however, will receive shares of the combined firm per share of Trulia, so Trulia s shares outstanding were adjusted to account for the exchange rate. This resulted in a share price of $ for the combined firm without synergy.

23 22 Table 10: Value of Combined Firm without Synergies Value of Combined Firm without Synergies Zillow Equity Value 3,881,172, Trulia Equity Value 2,155,825, Total Value 6,036,997, Number of share 56,685, Share price Next, we considered operating synergies. We do not believe that the acquisition will impact our forecast of the online real estate advertising industry, so we did not include higher growth rates, longer growth periods, or a lower cost of capital in our valuations. However, we do expect that the acquisition will increase efficiency and generate cost savings. Of the potential financial synergies, we do not expect diversification or cash slack to be applicable, due to comparably similar cash/asset ratios of the two companies. The only financial synergy that we viewed as plausible was the potential for tax benefits, since Trulia has reported a net operating loss of -$39,429,000 over the last three years. xxxiii To incorporate these synergies into our valuation, we adjusted the cash flows of the combined firm beginning in 2016 using the following assumptions: Revenue growth rate: We used a weighted average of Zillow and Trulia s growth rates in the fundamental valuation as the growth rates for the combined firm. The weighting was determined by the ratio of Zillow revenue to Trulia revenues from the past three years. Table 11. Growth Rate Weight Calculation Year Average Revenues for Zillow 197, ,850 66,053 Revenues for Trulia 143,728 68,085 38,518 Zillow percentage of the total revenue Table 12. Growth Rate for Combined Company Combined 75.79% 60.79% 56.93% 31.93% 31.93% 31.93% 20.00% 11.93% 11.93% 1.75% PPE/Sales ratio: We combined the PPE for the two firms and divided by the combined sales of the two firms. This was done over the past three years and

24 23 averaged to get the PPE/Sales ratio for future years. To incorporate operating synergies, we gave it a lower level schedule to indicate higher efficiency. Table 13. Average PPE/Sales Ratio Average Zillow 13.87% 14.50% 10.94% 13.11% Trulia 15.51% 10.38% 14.40% 13.43% Combined 14.56% 12.99% 12.22% 13.26% Table 14. PPE/Sales Schedule Year Schedule - 14% 13% 13% 13% 13% 13% 13% 13% 13% Depreciation/PPE ratio: We combined the depreciation for the two firms and divided by the combined PPE of the two firms. EBIT/Sales ratio: We used the same method as we did for the PPE/Sales ratio. And walked down 1% to indicate improvement of efficiency. Net Working Capital/Sales ratio: We used the same method as we did for the PPE/Sales ratio for the first year, and began decreasing the ratio steadily to account for improved efficiency of the combined firm. R&D/Sales ratio: We used the same method as we did for the Net Working Capital/Sales ratio. This accounts for the improved efficiency from combining R&D for the two firms. Tax: Taxes were calculated the same way as for the independent firms, except we used the combined net operating losses. Management costs: We expect management costs due to merging the two companies. In 2015, we assigned this value to 50% of the General & Management cost, and in 2016, it was only 30%. General & Management Cost was calculated using the average ratio of M&A/Sales from the past three years. Cost savings: We took a weighted average of the two companies announcements of expected cost savings. Zillow expects $145 million in operating synergies by 2016, and Trulia expects $175 million. xxxiv We used the average revenues of the companies from the past three years to determine the weights. Cost of capital: We used Damodaran s spreadsheet model and found the cost of capital to be as listed below: Table 15. Cost of Capital Zillow unlevered Beta Trulia Unlevered Beta Combined Cost of capital Stage % Stage % Stage % terminal %

25 24 Incorporating these assumptions in the cash flows of the combined companies, we found a share price of $ for the combined firm with synergies. Table 16 summarizes the equity value and share price of the combined firm with and without synergy. Thus, the value of synergy that the combined firm will have is $1.038 billion. Table 16. Valuation of Synergies Equity Value Stock Price Without Synergy $6.040 billion With Synergy $7.075 billion Synergy Value $1.038 billion Appendix C: Explanation of Different Scenarios for Standalone Companies In considering the standalone future of the two companies, we evaluated four different scenarios: our fundamental valuation; a high-risk scenario; a low growth rate scenario; and a negative stable growth scenario. The fundamental valuation is our original valuation based on historical financial data, outlined in Appendix A. The other three scenarios adjust growth rates and cost of capital of our fundamental valuation to account for various expectations of the future of the industry. Alternative 1: High Risk Referencing Aswath Damodaran s industry averages, the cost of capital for the internet services sector is 8.20% and the debt to value ratio for the industry is 4%. The average beta is The average cost of capital for the real estate industry ranges from 6.33% to 8.70% depending on the sector. Lastly, the advertising industry reports a 7.64% cost of capital based on these estimates. In our basic valuation, Zillow s cost of capital ranges from 5% to 6% while Trulia s ranges from 6% to 7%. Both of these values are below the average cost of capital for internet services, but well within the range for real estate companies. However, since the basic valuation incorporated very high growth rates into their projections, we believe that this may necessitate using a higher risk premium. This is due to the risk of the companies not achieving the high growth rates. Thus, we added a 5% risk premium to the cost of capital for each company. (The 5% was determined as a comparable risk premium to adjacent internet companies and would be derived from adjustments to Beta, the risk free rate, and the market premium.) As a result, the share prices of each company significantly fell: Zillow s share price was $33.19 under this scenario and Trulia s was $ In this scenario, both companies stocks are highly overvalued in the market. Alternative 2: Low Growth Our analysis of the online real estate advertising industry leads us to believe that there is a high possibility that the market is already close to saturation and that Zillow and Trulia

26 25 will have lower growth rates in their revenues than accounted for in the fundamental valuation. For this reason, we incorporated a growth schedule with lower growth rates into our second alternative for the standalone companies. The schedules we used for the two companies are given below: Table 17. Lower Growth Rate Schedule Basic Growth Rate for Zillow 70% 55% 55% 30% 30% 30% 20% 10% 10% 1.75% Lower Growth Rate for Zillow 60% 50% 40% 25% 25% 25% 10% 10% 10% 1.75% Basic Growth Rate for Trulia 85% 70% 60% 35% 35% 35% 20% 15% 15% 1.75% Lower Growth Rate for Trulia 70% 60% 50% 25% 25% 25% 10% 10% 10% 1.75% We held all other variable constant when adjusting for the growth rates. As a result, both companies stocks fell. Zillow s resulting share price was $62.93, and Trulia s share price was $ This indicates that if growth rates are lower than expected, both companies shares are overvalued in the market. Alternative 3: Negative Stable Growth Our final alternative also rests on our assumptions about the future of the industry. We believe that there is a possibility that the companies will be able to grow at high speed in the near-term future, but within ten years, the poor design of their revenue streams will inhibit further growth. In fact, the companies could actually see a decline in their revenues past this point. In this model, we changed the 1.75% growth rate used in the terminal stage of the fundamental valuations to -2.00%. This accounts for a decline in advertising revenues. Holding all other variables constant, this change results in a $48.55 share price for Zillow and a $26.72 share price for Trulia. Once again, both companies share prices are severely overvalued in the market given these assumptions. The results of our three alternative scenarios are shown below in comparison with the fundamental valuations used as our baseline. Both companies are sensitive to these adjustments, as each of the three scenarios negatively impacts the value of the firms.

27 Figure 1: Stand- alone Scenarios 26

28 27 Notes i Zillow Announces Acquisition of Trulia for $3.5 Billion in Stock. Zillow, Inc. 28 July Web. 15 Oct ii Zillow, Inc. 28 July iii Historically, shareholders in acquiring firms have been losers. A 2003 study by Moeller, Schlingemann, and Stulz (2003) finds that regardless of merger terms (cash versus stock or a combination thereof), shareholders of large acquiring firms most often see their wealth eroded. Over a twenty year period they find that mergers and acquisitions in the US had resulted in a loss of $226 billion but during this same period, shareholders of small cap firms reaped increases in wealth. The current cheap money environment of 2014 points to a pivot in this trend. with recent evidence finding that mergers may not be value destroying. However, if this trend has indeed reversed, it may be due more to lower and perhaps miss-specified costs of capital used in discounting future cash flows than in acquiring firms being more savvy today than was the case in the past. In fact, the evolution of the industry in which Zillow and Trulia operate is critical to the success of the merger. As we describe later, industry trends are not promising so ultimately the merger may fail. iv Control Premium Study RSM Bird Cameron Web. Page Oct v Trulia, Inc. Merger Litigation. Brodsky & Smith, LLC Web. 2 Nov vi Romano, Roberta. Question for [Sterling Professor of Law and Director, Yale Law School Center for the Study of Corporate Law] you. 21 Oct vii Alpert, Bill. Zillow s Shares Could Fall By Half. Barron s Online, 9 Aug Web. 20 Oct viii Zillow Audience. Zillow, Inc Web. 24 Oct ix Alpert, x Thompson, Derek and Jordan Weissmann. The Cheapest Generation: Why Millennials aren t buying cars or houses, and what that means for the economy. The Atlantic. 22 August Web. 27 Oct xi Kolko, Jed. The Recession s Lost Generation of Home Owners Isn t the Millennials It s the Middle-Aged. Trulia, Inc. 16 July Web. 29 October xii Trulia: Problems with real estate listings info are pervasive. Inman. 5 Oct Web. 24 Oct xiii Cook, John. This real estate vet is sick and tired of Trulia and Zillow, and he s not going to take it anymore. GeekWire, 31 Jan Web. 26 Oct xiv ARG is not all wrong about Zillow and Trulia. RealtyV Web. 26 Oct xv Holan, Mark. Why you might want to think twice before trusting Zillow s estimated value of your home. Washington Business Journal. BizBeat, 9 May Web. 23 Oct xvi Cook, xvii Alpert, xviii Yoder, Steve. Zillow and Trulia Face Backlash from Realtors. The Fiscal Times, 24 Feb Web. 24 Oct xix Henrich, Gena. Edina Realty pulls its real estate listings from third party aggregators. Edina Realty. 18 November Web. 26 Oct

29 28 xx Hammond, Grant. The Great MLS Listing Syndication War. Nashville Real Estate. 14 February Web. 30 Oct xxi Alpert, xxii Alpert, xxiii Alpert, xxiv Fundamental valuation depends on projected free cash flows and the discount rate applied to the cash flows. To support our belief that growth rates are overly optimistic, we used two approaches. First, we accounted for this impact by maintaining the growth rates and adding a risk premium to the cost of capital. Second, we kept the original cost of capital and adjusted growth rates. xxv Floro, Zachry. It would be a bad, bad thing if Facebook tried to charge users. Business Insider. 26 July Web. 29 Oct xxvi Alpert, xxvii Zillow, Inc. (NAS:Z) Short Percentage of Float. Gurufocus. 3 November Web. 3 Nov xxviii Jannarone, John. Trulia and Zillow insiders sold shares before merger report. CNBC. 24 July Web. 3 Nov xxix Star, Marlene Givant. Recent M&A Positive for Acquirer s Share Prices. Forbes. 13 March Web. 1 November xxx Damodaran, Aswath. The Value of Synergy. Stern School of Business. October xxxi Damodaran, xxxii Damodaran, Aswath. Acquisition Valuation. Damodaran Online Web. 18 Oct xxxiii Trulia, Income Statement. Operating Loss ( ). xxxiv Zillow, Trulia Management See Upside in Combined Company RBC Capital (Z) (TRLA). StreetInsider.com. 19 September Web. 27 October 2014.

30 29 BIBLIOGRAPHY Alpert, Bill. Zillow s Shared Could Fall By Half. Barron s Online, 9 Aug Web. 20 Oct ARG is not all wrong about Zillow and Trulia. RealtyV Web. 26 Oct Company Metrics. Zillow, Inc Web. 25 Oct Control Premium Study RSM Bird Cameron Web. Page Oct Cook, John. This real estate vet is sick and tired of Trulia and Zillow, and he s not going to take it anymore. GeekWire, 31 Jan Web. 26 Oct Damodaran, Aswath. Acquisition Valuation. Damodaran Online Web. 18 Oct Damodaran, Aswath. The Value of Synergy. Stern School of Business. October Edina Realty pulls its real estate listings from third party aggregators. Edina Realty. Edina Realty News, 18 Nov Web. 26 Oct Floro, Zachry. It would be a bad, bad thing is Facebook tried to charge users. Business Insider. 26 July Web. 29 Oct Hammond, Grant. The Great MLS Listing Syndication War. Nashville Real Estate. 14 February Web. 30 Oct Henrich, Gena. Edina Realty pulls its real estate listings from third party aggregators. Edina Realty. 18 November Web. 26 Oct Holan, Mark. Why you might want to think twice before trusting Zillow s estimated value of your home. Washington Business Journal. BizBeat, 9 May Web. 23 Oct How to buy a house online. Property Vibe. 26 Mar Web. 29 Oct Howell, David. How Accurate is Zillow s Zestimate? Not very, says one Washingtonarea agent. The Washington Post, 10 June Web. 24 Oct Jannarone, John. Trulia and Zillow insiders sold shares before merger report. CNBC. 24 July Web. 3 Nov

31 30 Kolko, Jed. The Recession s Lost Generation of Home Owners Isn t the Millennials It s the Middle-Aged. Trulia, Inc. 16 July Web. 29 October Miller, Peter. Will the Zillow-Trulia union change real estate? RealtyTrac. 30 July Web. 28 Oct Moeller, Sara B., Fredrick P. Schlingemann and Rene M. Slutz. Do shareholders of acquiring firms gain from acquisitions? NBER Working Paper No March NBER Programs. 31 Oct Romano, Roberta. Question for [Sterling Professor of Law and Director, Yale Law School Center for the Study of Corporate Law] you. 21 Oct Star, Marlene Givant. Recent M&A Positive for Acquirer s Share Prices. Forbes. 13 March Web. 1 November Thompson, Derek and Jordan Weissmann. The Cheapest Generation: Why Millennials aren t buying cars or houses, and what that means for the economy. The Atlantic. 22 August Web. 27 Oct Timiraos, Nick. Do Boring Explanations Explain Weak Millennial Homeownership? The Wall Street Journal. 24 July Web. 27 Oct Townsend, Daniel. Real Estate, Writing, and Beyond. n.d. Web. 29 Oct Trulia, Inc. Google Finance Web. 22 Oct Trulia, Inc. Trulia 2013 Annual Report on Form 10-K, Web. 16 Oct Trulia, Inc. Merger Litigation. Brodsky & Smith, LLC Web. 2 Nov Trulia: Problems with real estate listings info are pervasive. Inman, 5 Oct Web. 24 Oct TRLA Q Operating Metrics. Trulia, Inc Web. 25 Oct Yoder, Steve. Zillow and Trulia Face Backlash from Realtors. The Fiscal Times, 24 Feb Web. 24 Oct Zillow Announces Acquisition of Trulia for $3.5 Billion in Stock. Zillow, Inc. 28 July Web. 15 Oct Zillow Audience. Zillow, Inc Web. 24 Oct Zillow, Inc. Google Finance Web. 22 Oct

32 31 Zillow, Inc. (NAS:Z) Short Percentage of Float. Gurufocus. 3 November Web. 3 Nov Zillow, Inc. Zillow 2013 Annual Report, 17 Apr Web. 16 Oct Zillow, Trulia Management See Upside in Combined Company RBC Capital (Z) (TRLA). StreetInsider.com. 19 September Web. 27 October 2014.