Zillow-Trulia Good deal or tragic mistake?

Transcription

1 Zillow-Trulia Good deal or tragic mistake? Florida Southern College MBA Represented by: Melanie McDaniel James Pelham Michael Scott

2 Abstract Pending FTC approval, the $3.5 billion acquisition of Trulia by rival Zillow will create an online media giant, poised to capture up to 71% of unique web traffic to real estate sites. Reductions in cost due to SG&A overlap, increased R&D capabilities, and pricing power as a result of web traffic volume are the pillars on which this deal was founded. The forecasted market share and growth rates drive sentiment that the Zillow-Trulia deal wields a significant long-term upside for investors. We propose, however, that these assertions do not offset the negative internal and external factors surrounding this deal. The cost saving assumption is marginal compared to combined expense growth. Zillow is still overvalued and the fixed rate stock offer is terrible for Trulia stockholders. Furthermore, the pricing power preposition is heavily reliant on underlying contractual, market, and industry assumptions. Ultimately, this deal requires implementation of extensive and alternative growth strategies for long-term sustainability and success. Analysis of the Deal The acquisition offer presents potential upsides for both companies. Given that it is an all-stock deal, Trulia gets fully integrated as opposed to a cash option where Zillow would be free to purchase only the assets it wants and sell the rest. Additionally, Trulia receives the benefit of Zillow s liquidity. These appear to be the only upsides for Trulia. Zillow, on the other hand, receives much more. Zillow s key feature is its proprietary Zestimate algorithm for homeowners to check their home s value. Consumer sentiment, as a whole, is that the Zestimate feature is inaccurate or outdated in most regions, because it only considers value based on actual sales of comparable homes. The company has also pushed growth at the cost of speed and an easier user interface. Through its acquisition of Trulia, Zillow is getting a more data-driven and easy to use website. The company will benefit significantly from the abundance

3 of data at Trulia s command as well as having already begun to implement a new web design with more streamlined features. Operationally, Zillow is a predominately seller driven business whereas Trulia focuses on buyers and renters. A merging of the two companies specialized functions makes the most sense if the Zillow-Trulia deal hopes to be successful. Web-based real estate search sites, in the short-term, will not have a significant impact on the way people are buying homes. Home buyers still look to real estate agents to do the grunt work for them and that will be the case for a long time. The deal gives Zillow access to the necessary resources to change the future of the real estate industry and compete with brick and mortar realtor companies, some of which intend on developing their own web platform to compete with Zillow and Trulia. Pending closure of the deal, Zillow will walk away with all the upsides at absolutely minimal risk with respect to the acquisition. The terms of the Zillow and Trulia Merger Agreement further advance the position that Zillow is the advantageous party here. Trulia is severely limited in its ability to conduct business until the deal closes or is terminated. Pursuant to Section 5.01 of the Merger Agreement, Trulia cannot do anything but sustain operations without written consent from Zillow. [See Figure 1 for more detail]. This section enumerates 17 different material operations that Trulia cannot do, exposing the company to serious long-term risk should the acquisition fail. As with most contracts, there is language to financially protect both parties in the event the acquisition is not consummated. Each party owes a duty unto the other to pay a fee of $69.8 million in the event the contract is terminated as a result of entering into a Competing

4 Transaction Proposal. Trulia is also owed a duty by Zillow to pay $150 million if the deal does not go through on antitrust issues a fact that some analysts have keyed in on as being a huge detriment to Zillow. The contractual language, however, only obligates Zillow to pay this fee if it does not make reasonable efforts to obtain the necessary antitrust approvals. The requisite effort is reasonable by any M&A standards, limiting Zillow s exposure to the failure. The Merger Agreement also provides Zillow with the power to walk away from the deal if the government attempts to place any restrictions on the acquisition. Traditional merger clauses include an and statement restrictions exist and they adversely affect the company here, Zillow attorneys have included an or statement allowing Zillow the right to walk away regardless of whether or not the materially adverse condition is met. The Agreement was made on an all-stock basis, granting Trulia shareholders.444 shares of the newly combined company for every one stock of Trulia they own. (Pursuant to the Agreement, partial shares are redeemable for cash value). At the announcement of the acquisition, this meant Trulia was valued at over $70 per share, a 25% premium on the trading price that day. Again, however, Trulia is trounced by this deal. Since the announcement, both company s stock prices have decayed. Trulia was trading at $56.35 on July 25 and is now trading at $46.65, a decline in value of 17.2%. Accounting for the fixed exchange rate, if the deal were to close today, one Trulia share would be worth $ That is a decline in value of 32.5% from the premium price of $70.53 at the time the acquisition was announced. The valuation premium has been completely erased and Trulia is now trading at a 2% premium.

5 Analysis of the Future Neither company will survive the failure of this merger. Assuming Zillow fails to comply with the reasonable efforts standard in the Merger Agreement, the company will owe Trulia $150M. With current cash and cash equivalent holdings of $384 million, Zillow s failure to comply would cost them 40% of their current assets. The likelihood of this happening is marginal at best, as Zillow s legal team has a proven ability to beat the system. Should either company elect to enter into a competing acquisition, the associated $69.8 million dollar fee would wipe out 17% of Zillow s current assets or 30% of Trulia s $238 million. Seeing as this is another unlikely event, we now turn to operational analyses. Trulia s outlook pre-merger was bleak. The company s market share of organic search traffic has been in decline since the middle of 2012 [see Figure 2]. Losses attributable to shareholders are also increasing rapidly as the gap between revenue and net income has grown exponentially. Zillow is not safe from this trend either. Between 2012 and 2013, Zillow outspent its revenue growth so drastically, it completely reversed its YOY net income growth trends to below its pre- IPO levels. [Graphic representation of this data can be found in Figures 3 & 4 of the Appendix]. Neither company has included any statement in their 2013 annual reports or 2014 semi-annual reports indicating intentions, processes, or other means of cost cutting to reverse these trends. Rather, management of both Zillow and Trulia have stated that they will continue to scale the companies though expansionary spending. This poses a serious problem for Trulia. Given the language of the Agreement, they cannot make significant operational changes without Zillow s

6 permission. Trulia has thereby signed away its ability to better position itself in the market for long-term sustainability should the merger fail. A competitive analysis reveals Trulia and Zillow also face stiff competition from current and prospective real estate web sites. Move.com was recently acquired by News Corp with a nearly immediate potential to create an online brokerage to compete with brick and mortar realtors. Citron research published a portion of a Q&A between investors and Realogy the largest franchise in real estate agency [see Figure 5 for the excerpt]. In the discussion, CEO Bruce Zipf explicitly states they are building a site to directly compete with Zillow and Trulia to create their own business opportunities. This is possibly the most damning evidence that supports failure for both companies regardless of the merger. Realogy makes up 25% of the U.S. s real estate agency, with the next three competitors totaling only slightly above Realogy s number of agents. Furthermore, the company controls over 20% of the current Zillow/Trulia inventory, mostly in urban areas where revenue for advertising is highest. This is important to note because Realogy s internal site also has a visitor to lead conversion rate of 5.6%, 250% greater than all externally sourced leads [see Figure 6]. The company s advent and implementation of its own consumer facing website will directly and adversely impact the bottom line of Zillow and Trulia, jointly and separately. Should the merger succeed and Zillow-Trulia begins to operate jointly, the combined company has at least bought itself some time to figure out how to monetize a web-based real estate service platform. To recommend a buy in the combined company, however, an assumption would have

7 to be made that the specialized functions of Zillow and Trulia will be merged into one platform focusing on both the buyer and seller. The company would also have to shift its strategy from growth by expense to growth by diversified acquisition and partnership contracts. Eventually, Zillow-Trulia would have to become a one-stop-shop for home buyers. The market presents a unique opportunity where technology-mediated solutions may overtake much of the legacy role of the real estate broker. If handled appropriately, a single platform could manage the entire real estate purchase experience. This would result in higher lead conversions for realtors, making advertising on the Zillow-Trulia website more attractive thereby allowing the combined company to capitalize on the remaining 96% of the $12 billion spent on real estate advertising. Rampant cost cutting would also have to occur. The proposed $100 million savings post-merger will take until 2016 to be fully implemented, and is going to come mostly in the form of streamlining management and eliminating overlapping technology expenses. The biggest cost to both companies is their advertising expense to generate web traffic with the hopes of creating a power play in pricing negotiations. As outlined above, this is a dangerous game considering the shifting trends in the competitive outlook of the online real estate market and cost cutting will work to mitigate the risk associated with failure of the pricing power strategy. Assuming the companies independently release statements outlining a larger cost reduction strategy for longterm growth, we could be swayed to revise to a buy recommendation. Trading around the Zillow-Trulia Deal The foundation of our trading recommendation is based on a neutral sentiment with significant hedging measures. We propose that by using the right call options, an investor could realize over

8 1000% gain on his or her investment with all the downside risk completely hedged away by a merger arbitrage investment strategy. In order to substantially maximize possible returns on the Zillow and Trulia merger, a combined option schedule will be used. As previously described, the Merger Arbitrage strategy will bring a fixed 3.87% return as of October 31, We will use this profit to fund our Total Cost for the option strategy. After investigations, we chose to use a combined Condor and Butterfly spread with March options. This will allow us to capitalize on the pricing of Trulia around the months leading up to the merger. A condor spread [see Figure 7] is a simple option strategy in which the strategists employ a limited-risk, non-directional trade strategy to capture returns based off of low to limited volatility in stocks. In this case, we are going to buy two MAR calls and sell two MAR calls. The two MAR calls we buy will contain an ITM (in-the-money) call and an OTM (out-the-money) call. The two MAR calls we sell will also contain an ITM and OTM call. Of the two calls that are ITM, we will buy the lower strike price. Of the two calls that are OTM, we will buy the higher strike price call. This should create a spread that can be seen in the graph in Appendix X. A condor has limited profit and it can be achieved at maximum when the underlying stock price closes between the middle two strike prices. If the underlying stock price closes outside the maximum or minimum strike prices, this strategy results in the maximum loss of the cost of establishing the position, or net total cost. In addition to establishing a condor, we want to recommend adding a butterfly spread [see Figure 8]. The butterfly spread is a limited-risk, limited-profit strategy. While the condor has four strike prices, the butterfly only has three prices and results in a more pointed graph, as seen in

9 Appendix X. To establish the spread, a trader would purchase an ITM MAR call and an OTM MAR call, and sell two ATM (at-the-money) MAR calls. In this strategy, the maximum profit is realized when the underlying stock price doesn t change from the ATM calls, as only the lower strike call will be ITM. If the price of the underlying stock appreciates past the OTM call or decays past the ITM call, then the trader would realize the maximum loss possible, which is the net cost of establishing this position. To show this strategy with actually numbers, assume the price of contracts on October 31, Trulia (TRLA) closed at $ To establish our combined condor-butterfly spread with a single set of contracts, you would need to purchase the following contracts: 2 MAR 42 with a $16.80 premium and 2 MAR 50 with an $11.40 premium. Then you would need to sell the following contracts: 1 MAR 43 with $16.10 and 3 MAR 47 with a $13.30 premium. This spread results in a net cost of $0.40 to establish. With $41.96 as a minimum and $50.08 maximum, this spread will receive a profit between the two boundaries. Outside these boundaries, an investor will realize a loss up to the maximum of $0.40. The maximum gain for an investor will be just passed $47.00 around $5.25 per set of contracts. The gains and losses on this option strategy are inherently and excruciatingly important for our strategy. Due to the merger arbitrage spread, investors can use the profit from the spread to cover the costs of the option strategy. If you wanted to amplify your returns by a factor of 1000 to $5,250 from the option spread, you would simply purchase and sell the above option strategy by a factor of You would then realize a cost of $400. By going long in TRLA with 250 shares, and going short in Z with 111 shares, you would achieve a $406 profit, due to the fixed

10 conversion spread. In combining this strategy, you eliminate any potential loss and leave yourself to a maximum gain just above of $5.25/contract set or just above $5,250 in this scenario. This is possible and likely due to the decaying trend of Trulia and Zillow stock prices, which correlate by a coefficient of 0.99 since the July 28 th, 2014 and 0.85 since January 3, 2014, but are also buoyed by a gravitation of the price towards $45 for Trulia. Even though the price of Trulia should gravitate towards $45, between October 31, 2014 and March 2015 the price could ebb and flow to $47, resulting in the maximum possible gain. The option strategy s potential downsides can be hedged away completely with a merger arbitrage strategy. A merger arbitrage trade for an all-stock M&A proposal requires going long in the target company and shorting the acquiring company at a rate equal to the fixed exchange rate. Here, an investor would go long 1 share of Trulia and go short.444 shares of Zillow. Closing prices on October 31, 2014 for Zillow and Trulia were $ and $46.65, respectively. The 1 to.444 valuation ratio creates a 349 basis point spread, or 3.49% return (8.37% annualized) via the merger arbitrage investment strategy. To completely offset the loss potential of the options strategy, an investor must purchase 250 shares of Trulia and short 111 shares of Zillow for every 1000 options contract combinations purchased. The investment pays for itself and the long-term return at the time of the closing will completely negate the sunk costs of the options if they expire out of the money. Given that our portfolio is using merger arbitrage as a hedging against losses on the options contract, we do not recommend the use of leverage to generate higher returns.

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12 Appendix Figure 1 Section 5.01 of the Zillow-Trulia Merger Agreement Figure 2 Trulia s Organic Market Share Decline

13 Figure 3 Trulia s Revenue & Net Income Spread Figure 4 Zillow s Revenue & Net Income Spread

14 Figure 5 Excerpt from Realogy Investor Q&A

15 Figure 6 Realogy Lead Conversion Figures 7 & 8 Condor & Butterfly Spread Illustrations

16 Figures 9 to 11 are snapshots of Excel worksheets used to generate the investment recommendations outlined in the body of this paper. All calculations based on closing prices on 10/31/2014. Figure 9 Zillow-Trulia Stock Price Correlation pre- and post-merger announcement Figure 10 Options Contract P&L Forecast

17 Figure 11 Merger Arbitrage Projections

18 Works Cited Duprey, Rich.(2014). Zillow and Trulia s house might be more straw than brick. Retrieved from Citron.(2014). Zuliagate-the big secret. Retrieved from Giles, Justin.(2014). The Zillow-Trulia merger: looks like it's time to Start selling your shares Glimpses, Edgar. (2014). TRULIA, INC. files (8-K) disclosing entry into a material definitive agreement, other events, financial statements and exhibits. Retrieved from Hoak, Amy.(2014). How the Zillow-Trulia deal affects online home search. Retrieved from and go short. Retrieved from Kasanoff, Bruce.(2014). Are real estate brokers obsolete? Retrieved from

19 Solomon, Steven Davidoff.(2014). In real estate listings deal with Zillow, Trulia bears most of the risk. Retrieved from Pinebridge Investments.(2014). Merger arbitrage: beyond deal or no deal. Retrieved from SEC.(2014). Agreement and plan of merger. Retrieved from htm Seeking Alpha.(2014). Trulia shareholders: congratulations, but you should sell right now. Retrieved from