Running head: ZILLOW AND TRULIA, A REAL ESTATE MERGER 1. Zillow and Trulia: A Real Estate Merger. Wagner College. Giuseppe Badalamenti

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1 Running head: ZILLOW AND TRULIA, A REAL ESTATE MERGER 1 Zillow and Trulia: A Real Estate Merger Wagner College Giuseppe Badalamenti Nicholas De Matteo Kenneth Whitman

2 ZILLOW AND TRULIA, A REAL ESTATE MERGER 2 In 2005, two online real estate databases were founded to accommodate the growing presence of the virtual real estate services market in the United States. Headquartered in Seattle, WA, Zillow was founded by Rich Barton and Lloyd Frink (Zillow, 2014); Trulia, headquartered in San Francisco, was founded by Sami Inkinen and Pete Flint (Trulia, 2014). Zillow and Trulia currently stand as the largest entities in the online real estate services market, a rapidly expanding market new to the real estate industry. Twelve billion dollars are spent annually on marketing for real estate agents and firms. (Zillow, 2014). Both companies provide similar services to their rapidly growing user base, which consists of both everyday consumers and industry agents alike. Their services include providing potential home-buyers, sellers, and renters with unique insights and information about properties within the United States, and they also provide the ability for these aforementioned parties to connect with the best agents in said prospective areas. Through acquisitions, such as Trulia s acquisition of Market Leader, and partnerships, such as Zillow s cooperation with Yahoo! Homes!, the two firms provide real estate agents with easy access to tools that enable them to better manage and grow their businesses (Zillow, 2014). Currently, Zillow is the larger of the two firms, with 83 million unique users as of June 2014, which also makes it the largest company in the online real estate industry; Trulia falls in second with 54 million unique users. Combined, Zillow and Trulia dominate approximately 61% of all users in the online sector (De La Merced, 2014). Earlier this year, in July, the two firms announced that Zillow would be acquiring Trulia in an all-stock deal. The agreed upon deal states that Trulia shareholders will receive.444 shares of Zillow stock for each share of Trulia stock held. Once the deal closes, Trulia shareholders will represent approximately one-third of the new combined entity, while Zillow shareholders will represent the remaining two-thirds. The purpose of the merger, according to both parties, is

3 ZILLOW AND TRULIA, A REAL ESTATE MERGER 3 to help the companies grow in a brand new and upcoming market, as well as to cut costs in order to positively add to the bottom line. If analytical projections are accurate, the Zillow-Trulia merger deal will lead to $100 million savings in cost by 2016, much of which will come from a reduction to operating expenses. At the close of the deal, a larger part of Trulia s staff will be let go from their positions and the remaining, such as the CEO and one member of the board of directors, will be integrated into the new company under the Zillow majority (De La Merced, 2014). Currently, both companies are struggling to achieve profitability. Since its IPO (Initial Public Offering) in 2012, Trulia has not posted a profit as per the GAAP (Generally Accepted Accounting Principles). Zillow posted its first loss in 2013, recording weak profits in prior years. Both companies have grown their revenues year after year, showing positive growth; Trulia and Zillow revenues have grown 273% (Trulia SEC Filing, 2013) and 199% (Zillow SEC Filings, 2014), respectively, since However, their operating expenses have continually exceeded their revenue growth: Zillow has seen their SG&A (Selling, General, and Administrative) expenses expand 336% (Zillow SEC Filings, 2014), while Trulia has seen those expenses grow 222% (Trulia SEC Filing, 2013) within the same time frame. In the case of both firms, the losses can be attributed mainly to their ballooning operating expenses. Unless the firms can find a way to outpace their expenses with sales growth, they cannot hope to achieve profitability without implementing sharp reductions in operating expenses. A key aspect would be the ability to control the expenses without affecting the quality of the websites. Should the merger fail, both companies would be back to battling the same concerns they had been facing before the announcement of the deal. Due to the inabilities of both firms to control their expenses thus far, the possibility of continued success could be problematic.

4 ZILLOW AND TRULIA, A REAL ESTATE MERGER 4 While much of the two companies revenues are attributed to real estate advertising, either have yet to make substantial headway into capitalizing on the $12 billion market. Trulia has not posted a profit since its IPO in 2012, and both Trulia and Zillow are projected to post GAAP adjusted net losses this year. According to Bill Alpert s article in Barron s, realtors are not willing to pay the fees for advertising on the two websites due to the fact that online traffic consists mainly of lookers, as opposed to buyers. Currently, the two companies offer discounts to the largest real estate firms, such as Realogy Holdings, in order to draw in business. Such practice shows a lack of pricing power by the two firms, and points to the very real challenge of migrating the larger real estate market onto online platforms. Crye-Leike, a real estate agency focusing on properties in the Mid-South of the United States, recently removed all advertising placements from both Trulia and Zillow in response to a pricing increase. One agent was quoted as saying We don t need them now (Alpert, 2014). This demonstrates how online firms are struggling to gain a strong demand on their own in the contemporary real estate market. A successful merger between the two firms can have a substantial positive effect on advertising sales, which would greatly improve their combined income statement, with the very real possibility of reducing duplication of services. Currently, Zillow is estimated to hold a 37% market share in the industry, while Trulia maintains a 24% market share; If the two entities were to combine, their market share of 61% could increase their pricing power and help solidify their footing in the long-run (De La Merced, 2014). Real estate agencies would be more limited in their options of advertising on the Internet, since Zillow and Trulia would be controlling a large majority of all internet traffic. The resulting combined entity would also benefit from a much better economy of scale. By eliminating the majority of redundant jobs, a substantial savings should be accomplished, thereby resulting in a sharp reduction of fixed costs. Given that both

5 ZILLOW AND TRULIA, A REAL ESTATE MERGER 5 firms operate with similar websites, mobile applications, and software, they would be free to cut back on the high costs of employing programmers as well as any other similarly tasked employees. Alone, the two firms would still face an uphill battle of cost-cutting, which could possibly damage operations and growth. However, the new, larger combination would be more powerful and efficient, hopefully projecting them into a more stable position within the future of online real estate advertising. The merger s success may be vital to the future of both Trulia and Zillow, although Trulia would stand to gain more benefits from the deal than Zillow would. Trulia shareholders will profit from the synergy of the combination, and hopefully, regain the premium their stock enjoyed on the day of the announcement. Also, Zillow has many more unique users to bring into the new firm. According to a report on Zillow s Investor Relations blog, of Zillow s 83 million unique users, two-thirds do not visit Trulia, and of Trulia s 54 million unique users, only half do not visit Zillow (Zillow, 2014). While the success of the deal should add value to both firms, there are many possible impediments that may need to be overcome. One such hurdle could be the FTC (United States Federal Trade Commission). The Federal Trade Commission, the regulating body for all public company mergers and acquisitions, may not allow the merger to take place for fear of the combined entity of Trulia-Zillow monopolizing the industry. The structure of the Trulia-Zillow merger makes the most strategic sense for both companies, but it may result in the formation of an online powerhouse, which could prevent the acquisition from being approved by the FTC due to antitrust laws and regulations. Both companies have been struggling to post profits due to high operating costs and the resultant corporation would be able to eliminate much of these redundancies. However, the deal is subject to the satisfaction of customary closing conditions,

6 ZILLOW AND TRULIA, A REAL ESTATE MERGER 6 including the expiration of U.S. antitrust waiting periods and shareholder approval of both companies (Zillow Inc., 2014). Due to antitrust laws preventing the monopolization of industries, this deal has raised red flags with the Federal Trade Commission and could hinge on whether the agency views all realestate advertising equally or instead distinguishes between online ads and those outside cyberspace (Kendall & Light, 2014). The Federal Trade Commission will also review the barriers to entry for this merger, including the substitutability of both Zillow and Trulia before giving approval. The FTC s main concern centers around the effect on customers: if the new deal hurts customers or the user experience, then the deal may not be allowed to process. In addition, the FTC may require that some segments of the combined businesses be sold off in order to maintain adequate competition in the case that they become too dominating. Another possible obstacle to the deal could be the current state of the merger arbitrage market. In the recent past, many mergers have failed to close for a variety of reasons that have hurt these event-driven investments. For example, 21 st Century Fox and Time Warner failed to close an $80 billion merger at the same time that Sprint abandoned plans to acquire its rival, T- Mobile. These very large, failed deals have caused hedge funds and large players in the merger arbitrage market to post steep losses. Many mergers have also failed due to the government s curbing of tax-driven mergers, known as tax inversions. Since President Barack Obama announced the intention to more closely examine such tax inversions, deals driven by tax purposes have failed to close, further impacting the merger arbitrage market. Deals, such as one between Shire and AbbVie, failed to close due to the fear of government regulation, which, in turn, caused serious losses within the arbitrage community (Hoffman, 2014).

7 ZILLOW AND TRULIA, A REAL ESTATE MERGER 7 The California Public Employees Retirement System (CalPERS), the largest pension fund in the United States, has recently announced it would remove hedge funds from its investment portfolio to reduce complexity and costs (Stewart, 2014). The announcement came after the many failed merger deals in the previous month. It is thought, given the size of the investment fund, that certain comparable investment portfolios will possibly follow suit. Many similar funds, such as the California State Teachers Retirement System, the second largest pension fund in the United States, announced that it would be evaluating the position of hedge funds in its portfolio (Fitzpatrick, 2014). The possible large exodus of these pension funds could very well hamper the hedge fund industry s ability to play in the merger arbitrage market. The tax inversion discussion hurt potential mergers and the stocks of Zillow and Trulia witnessed a great deal of volatility and their stock values plummeted. On the date of the announcement, the stock values of both firms reached all time highs with Zillow trading at $ and Trulia at $ As of October 29, 2014, Zillow and Trulia stock prices have fallen 33.8% and 30.9%, respectively (Yahoo Finance, 2014). While it can be said that the overall stock market has seen a great deal of volatility in 2014, the S&P 500, in the same time frame, has decreased 0.72%. The decline in their market values may be a sign of waning investor confidence in the outcome of the deal, or the success of the company post-merger. Although the two firms have to face major obstacles in their merger, they will most likely be successful in their quest. In all likelihood, the FTC will permit the two companies to complete their deal due to the ease of entry and the unlikely scenario of the consumer being hurt by the merger. Users of both websites will have the benefit of receiving the best service without any additional hassle, or any extraneous cost. In addition, the consumers may also benefit from cost reductions of economy of scale and perhaps receive cheaper prices if post-deal Zillow

8 ZILLOW AND TRULIA, A REAL ESTATE MERGER 8 allows a flow through. Real estate professionals may be potentially threatened by this occurrence, but the online market is still small enough compared to the overall market, leaving agents with other options to turn to for advertising. A major component of the FTC s review process deals with barriers to entry into a market, which is virtually non-existent in regards to online real estate. The market is still new and has not garnered much attention, but, should it take off, firms will be able establish themselves fairly easily and create more competition. The optimism surrounding the merger can be seen in the market spreads, with the stock spread standing at 9.4% (Yahoo Finance, 2014), as expected, at the inception of the deal. However, the spread immediately began to tighten and has now stabilized to hover around 5% (Yahoo Finance, 2014). Although the stocks have lost value, the stable spread shows that investors are confident that the deal will proceed as planned and be approved by the FTC. Over the next several months, should that optimism continue the spread should be seen tightening to a minimal amount. Although the merger will most likely be successful, the future of the combined entity is still in question. In 2013, combined revenues for both firms were approximately $342 million (Zillow Investor Relations & Trulia Investor Relations, 2013). While they would make up 61% of the online segment, they would be only 2.85% of the entire real estate industry. The online real estate market is, as previously stated, a space full of lookers and has yet to find major traction, leaving it unclear as to how revenues will be increased. Unless the two companies can turn the passive lookers into active buyers by directly connecting agents with clients, revenue growth will plateau as agents pursue cheaper advertising mediums. Also, the combined entity will most likely not have much more pricing power, due to their holding of small and untapped positions in a huge market. The agencies unwillingness to use either firms shows a low demand

9 ZILLOW AND TRULIA, A REAL ESTATE MERGER 9 for this medium of real estate advertising. The biggest downfall for the combined entity will be the market s growth. Should the firm find a way to explode the online real estate market, competitors will not sit idly by. With a combined market cap of $5.83 billion, the firms would not be able to compete if a firm such as Google, with a market cap of $373 billion, expands into the real estate advertising market. Despite the high probability of the deal going through, the doubt of the combined firm s success makes a long position in the new firm strategically inadvisable. Therefore, in our opinion, the best investment position would be to write put options on each share. Writing put options would provide more comfortable risk, based on the historical price movements of each stock. As the deal approaches fruition in the first quarter of 2015, we would expect a stabilization of the stock prices. Our strategy will be to write several puts on each company with January 2015 expiration dates. On Zillow, the acquirer, we will write two puts with strike prices of $90 and $100; On Trulia, we will write two puts with strike prices of $35 and $40. Given that Zillow and Trulia have lost a considerable amount of value over the past several months, our decision to write puts is due to current and past stock valuations. Two weeks prior to the announcement of the deal, Zillow and Trulia s stocks were valued respectively at nearly $126 and $39 and moved up substantially in anticipation of a deal announcement. Due to the probability of the deal s closing, it does not seem likely that either stock will fall below their current valuations due to their proximity of pre-deal levels. Although there is the danger of the deal failing to close, our risk is limited given the current values. The Trulia puts are more aggressive, as they are closer to being in the money. As of October 29th, Trulia closed at $ Should the deal unravel, Trulia would be in danger of losing value as arbitrageurs leg out of their positions, posing the most amount of risk

10 ZILLOW AND TRULIA, A REAL ESTATE MERGER 10 to our strategy. However, this creates the exact scenario for our bullish put strategy, buying Trulia below where it was trading pre-deal announcement. We are willing to bear the risk of this occurrence because the option will be exercised, putting us in a long position at a level we feel confident that will provide us with substantial upside potential. Since hitting the low $100s, Zillow stock has stabilized as the overall market has improved. Being that Zillow is the acquirer, should the deal break, its value will most likely increase as arbitrageurs cover their short positions. Also, with an early expiration date, the securities may be subject to a year-end rally that will boost their prices right before expiration, adding to our potential profitability. The more aggressive options written, Trulia for $35 and $40, will secure a profit of $2.85 per share, should the value remain stable or increase at the time of expiration. In January, once the option expires, the Zillow puts will secure us $12 in profits for each contract written. In order to truly capitalize on this deal and make our strategy more dynamic, once our options decrease in value to less than $2.00 each, we will, taking into considerations market conditions, roll our Zillow puts into May. We will not consider writing new Trulia options and will concentrate instead on our singular position on Zillow. We feel that this dynamic portfolio management strategy reflects the solid result of our overall research regarding where the stocks were when the deal was announced, and where they are now. We have also taken into account the general market and the probability of the deal going through, which therefore allows us to profit, despite the possibility of the deal s failure. Our strategy is reflective of our risk appetite and may not be suitable for more conservative investors.

11 ZILLOW AND TRULIA, A REAL ESTATE MERGER 11 Works Cited Alpert, B. (2014, August 9). Zillow Shares Could Fall By Half. Retrieved October 31, 2014, from: De La Merced, Michael J.. (2014, July 28). Zillow to Buy Trulia for $3.5 Billion in All-Stock Deal. Retrieved October 24, 2014, from Fitzpatrick, D. (2014, September 15). Calpers to Exit Hedge Funds. Wall Street Journal. Retrieved from ?KEYWORDS=calpers Hoffman, L. (2014, August 7). Merger-Focused Mutual Funds Avoid Hedge Funds Big Losses. Retrieved from Kendall, B., & Light, J. (2014, September 8). Review of Zillow-Trulia Merger Hinges on Advertising. Wall Street Journal. Retrieved from Premerger Notification and the Merger Review Process. (n.d.). Retrieved October 27, 2014, from Stewart, J. (2014, September 26) Hedge Funds Lose Calpers, and More. The New York Times. Trulia Investor Relations. (2013) Trulia 2013 annual SEC filings of financial statements. [Charts] Retrieved from the Trulia Investor Relations website: ir.trulia.com/phoenix.zhtml?c=251458&pirol-sec

12 ZILLOW AND TRULIA, A REAL ESTATE MERGER 12 Zillow Inc. (2014, July 28). Zillow Announces Acquisition of Trulia for $3.5 Billion in Stock [Zillow blog]. Retrieved from Zillow Investor Relations website: Zillow Investor Relations. (2014). Zillow 2013 annual SEC filings of financial statements. [Charts] Retrieved from the Zillow Investor Relations website: Zillow. (Z). Historical Prices from July 28 - Oct 31, Yahoo!Finance. Retrieved from