The Economist | Which MBA?

MBA Case Competition November 2014

Truzilla: An Evaluation of the Zillow-Trulia Merger

and the Birth of an Online Advertising Monster

Presented by:

Will Cappelletti, Steve Gabster, Bertrand Louvard

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Introduction

In July 2014, online real estate listings websites Zillow and Trulia announced that Zillow would

acquire Trulia in a $3.5bn all-stock deal. The following report examines this merger by

identifying the real winners, digging into the structure and rationale for the deal, and evaluating

two future scenarios depending on whether the deal is successfully completed. The report

concludes with an assessment and recommendations for trading actions around this acquisition.

Winners & Losers

It is a well known trope in MBA classrooms that many even most M&A deals fail and

ultimately destroy value. On the surface, the Trulia acquisition appears to be yet another over-

valued transaction fueled by already over-valued valuations and coaxed along by large tech

industry egos and M&A advisors seeking ever-higher fees. The market has been relatively

patient even encouraging of these transactions in recent months. It is tempting to think that

this acquisition is just another example of managerial hubris with regard to Zillow CEO

Rascoff's contention that the deal will create value. In fact, initial market movements greeted the

acquisition announcement with a surge of support for Trulias prospects, while Zillow received

much softer support. On July 28, 2014, the day the deal was announced, Zillows all-stock offer

was valuated at $3.5bn, representing a 25% premium on Trulias market value. Although both

companies subsequently saw the price of their shares rise, Zillows shares rose only by

approximately 1%, to $160.32, while Trulias shares rose 15%, to $65.04.i A deeper

investigation of the underlying nature of the real estate industry, however, will serve to illustrate

why investors may be erroneously evaluating this acquisition.

First, it is important to note that both companies generate revenue largely through sales of

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subscription services and advertisements for listings to real estate professionals. Provided the US

Federal Trade Commission (FTC) approves the merger, the terms of the deal appear attractive to

both parties stakeholders. The deal suggests that the combined entity will largely keep existing

structures in place, merge leadership (Trulias CEO will join Zillows board), and continue to

serve the two firms relatively distinct end-user populations. It achieves all of this while also

pooling resources to realize cost savings and improve the companys ability to serve and capture

online advertising revenue.

Indeed, given these conditions, it initially seems reasonable to argue that Trulia perhaps got the

better deal by burrowing itself at a significant premium into the market leader. Both Trulia

and Zillow had been attempting to disrupt this industry, but Zillow was arguably having more

success given its larger consumer and revenue bases and success in poaching top talent from

rivals such as Move, Inc. As the second player in the industry, Trulia was posting strong gains in

terms of user growth, but had failed to capture the markets attention in the same manner as

Zillow had given its weaker market cap. The argument goes that Trulia traded in their short-term

and potentially unsustainable user growth momentum for a 25% payout while allowing its

leadership to continue their mission from within Zillow.

Additionally, from an industry angle, if Zillow is successful in consolidating and dominating the

fragmented online real estate advertising market, it will realize a large revenue benefit.

While both firms technically stand to benefit from the combination, the legacy Zillow team will

benefit more given the sites pole position as the market leader, making it best placed to succeed

in consolidating online real estate advertising.

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There is already evidence that consumer behaviors are rapidly changing, with analysts estimating

that more and more upfront research in the last five years has moved online and away from

agents and brokers. Real estate ad sales are highly fragmented and it is, according to Zillow, one

of the rare industries where ad sales have not yet migrated en masse to the internet.ii The two

companies, whose websites represent 48% of all web traffic among consumers looking to buy a

new home, today represent just 4% of the $12 billion currently spent on real estate advertising.iii

This presents ample room for growth. Further, with regard to online web traffic, the combined

entitys nearest competitor, realtor.com, had less than one half of the web traffic of Zillow and

under three quarters that of Trulia.iv Realtor.com would have less than one third of the combined

entitys traffic.

Evidence of this potential disruption to the current way of doing business between consumers

and realtors is apparent in some of the statements of real estate agents and industry experts, who

have expressed concerns about the potential market power of the combined company.v By setting

up a near-monopoly in a rapidly growing market, Zillow will have the option to command higher

premiums for its ad sales as well as the subscriptions it sells to real estate professionals.

Deal Structure

The deal is structured as an all-stock transaction, with no exchange of cash. From Zillows

perspective, this approach is sensible for a number of reasons.

First, according to Zillows 10-Q filings, the company is in a tight cash position. While the firm

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has $138mn cash on hand at the end of June 2014, it saw net outflows of roughly $60mn in that

quarter, and roughly $48mn in the preceding quarter, rapidly depleting a cash position that was

over $300mn in September 2013.vi These outflows were largely the result of rising sales and

marketing expenses, acquisitions, and investments in engineering and technical professionals.vii

With this precipitous 60% drop in Zillows cash balances across a nine-month period, it is highly

unlikely that another structure for the deal might have emerged in this time period from Zillows

perspective.

As illustrated in Figure 1, Zillows share performance versus Trulia over the preceding five

months may be a second factor influencing this decision. Zillows initial outperformance

appears closely timed with the hire of Chief Industry Development Officer Errol Samuelson,

who previously served in numerous senior positions at competitor Move Inc.viii While Mr.

Samuelsons track record of industry success is impressive, Zillows executives may have

perceived the markets approving reaction as an opportunity for cheap equity financed

acquisitions. As the companys market valuation climbs, the degree of dilution to shareholders

required to finance the acquisition falls. Additionally, an all-stock deal removes the eventuality

of an industry/segment valuation arbitrage (similar to the case of AOL buying TimeWarner

based on different valuation models and multiples), removing the risk of investors being unduly

diluted: they receive a quid-pro-quo rather than a totally different package.

From Trulias perspective, if they felt their short term momentum was unsustainable and that the

potential for market growth with regard to advertising with online real estate was strong, it made

sense for them to make a deal with Zillow. The company still holds onto upside potential within

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the market through Zillow stock rather than selling out for cash.

Figure 1: One-Year Historical Price Comparison of Z vs. TRLA (Source: Google Finance)

Future Forecasts

Like many online service businesses, the online real estate listings market today is characterized

by elements of a platform business. Zillow, Trulia, and other industry players find themselves

competing for the critical mass of users necessary to become the dominant player in real estate

advertising. The more users regularly visit a firms portfolio of websites, the more relevant and

essential the firm becomes in the larger residential real estate industry, thus attracting more

consumers and real estate professionals. Success breeds success, and dominant platform

businesses outside the real estate space have experienced this phenomenon. Over time, in such

markets, a dominant player emerges who controls a majority of all traffic and reaps the resulting

rewards. It becomes increasingly difficult for other market participants to engage in the industry

without maintaining some form of presence with the platform business, and so the industry

leader is able to translate its dominance into a degree of pricing power. A critical mass

scenario such as this generally arises under conditions where (1) large costs are incurred to use

more than one product, (2) positive network effects are present, and (3) individual choices are

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difficult to differentiate. All three of these conditions are present in the online real estate listings

space.

Notable examples of successful dominant players who have similarly met these conditions

include Amazon.com and Apples iTunes platform, but an even more relevant example is

Autotrader.com. As its name suggests, Autotrader involves the purchase of the next most

complex and expensive product for most Americans aside from their home: a car. And their

business model is quite similar to that of Zillows: to build a strong base of consumers searching

for car listings and to sell subscriber packages to dealers looking to list their automobile

offerings.ix

Scenario I: Deal Closes, Companies Merge

If the anti-trust authorities bless this merger, several factors must still be in place for the

combined entity to present a worthy investment opportunity post-announcement. With the

online listings segment today capturing just 4% of the $12bn in advertising spent by realtors each

year, the first factor required is that consumer preferences must continue to evolve favoring

online-type listings and, implicitly, the Zillow/Trulia combination.

While this assumption would lead to more unique users visiting the Zillow and Trulia websites

each month, the conversion of this user volume into advertising-led revenue growth requires

additional factors. Specifically, this will depend on growth in the volume of visitors to the site

who make serious enquiries to realtors about buying, renting, or selling a home in order to

convince realtors to put more of their advertising dollars into the combined entity. At present,

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there remains some skepticism about the firms ability to serve as more than a novelty for

visitors who want to snoop on their neighbors home values.x The two entities have already

taken steps to increase the stickiness of their user bases by actively catering to different market

segments (sales, rentals, home improvement, mortgage, professional services, etc.) and

geographical locations (urban, suburban, niche markets e.g. recently acquired StreetEasy in

NY). As a combined entity, Zillow/Trulia will strive for economies of scope by extending its

existing platforms to serve different types of customers for different kinds of needs, but the

combination will also allow them to reach critical mass faster. Companies in this space are likely

to attract die-hard users in each of the different core segments in which they operate, thus

increasing the initial usage to a minimum traffic, which in turn will attract other types of users.

Moving beyond site visitor volume, a combined firm also requires strong relationships with

content providers the real estate brokerages and MLS intermediaries. These players draw their

revenues from transaction volume and value, and so it is in their interest to gain broad exposure

through cooperation with popular consumer search channels. A Zillow-Trulia combination

would power listing advertisements for three of the top five real estate sites, thus creating a

market leader which consumers set as their default destination for property searches and to which

content providers reliably provide content. This dominance reduces the incentive for content

providers to create new platforms as alternatives to Zillow-Trulia. Attempting to drive traffic to

these potential sites would essentially require firms to cease advertising listings on Zillow and

Trulia, which in turn would likely provoke a consumer backlash. Thus, content providers will

continue to comply.

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Scenario II: Deal Fails to Close, Companies Remain Independent

If the online real estate listings market fails to consolidate, fragmented industry players will find

themselves facing low growth prospects as they fail to cooperate to drive more extensive access

to MLS listings. Real estate content suppliers are significantly less centralized and organized

than those in the travel industry, and the lack of clear market leadership will slow the pace of

online adoption as no champions exist to partner with and drive change among the brokers and

MLS services. As discussed earlier, Zillow will still likely prevail in the short term as a non-

dominant market leader grudgingly tolerated by content providers. But over time, lacking strong

growth, the industry will face a war of attrition, and the most well-financed firms will endure,

perhaps as subsidiaries of much larger entities (e.g. Moves acquisition by NewsCorp).

Recommended Trading Strategies

We will explore trading strategies that will help us benefit from the scenarios we have

highlighted above.

In particular, we will consider non-trivial trading strategies benefiting from irregular trading

patterns in the industry due to possible future merger/acquisition activity. Those strategies will

involve options (hedged and unhedged) that will allow us to profit from the potential outsized

returns (both on the upside and on the downside) surrounding merger announcements and deal

unwindings, leveraging the non-linear returns of options strategies.

On another note, it is worth highlighting that this is the first time in recent history (2007) that so

many announced deals have collapsed before completion, either due to a lack of adequate

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financing or regulatory concerns. For those reasons, it is useful to consider strategies that would

benefit from the collapse of the proposed deal among other scenarios.

Scenario I : Deal closes and industry continues to consolidate

In the event the deal closes, the combined company could either continue its buying spree and

independent competitors could become the targets of new public bids. Alternatively, as in the

case of NewsCorps bid for Move Inc., classic online media companies could enter this still

highly fragmented market and diversify their digital advertising assets.

To illustrate this phenomenon, we focused on HomeAway, Inc. (Ticker AWAY), a publicly

traded comparable company whose liquidity is large enough to allow for large trades to be put in

place. Similar strategies could be considered for other publicly traded competitors.

A public bid would command a premium compared to current trading levels (a benchmark of

25% doesnt seem unreasonable considering the growth of the industry and the history of

comparable mergers). To benefit from the leg up after the announcement, buying, on a rolling

basis, short-term (e.g. three months) out-of-the-money calls (110% strike, displaying excess

convexity in the short-run) would be sensible. On the other hand, in order to mitigate the risk and

finance expensive rolling purchase of short-term out-of-the-money calls, we would sell long term

(one to two years) out-of-the-money calls (125% strike, above projected premium in case of a

deal).

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This rolling calendar spread would benefit from a merger announcement in two ways (see

Appendix I for calculations and scenario):

i. The long leg would see its value increase dramatically due to spot rising fast (order 1 delta

effect + order 2 gamma effect and convexity);

ii. The short leg would suffer on the order 1 but not as much on the order 2 (less convexity on

long term options). However, it would greatly benefit from the collapse of the implied

volatility following the merger announcement. Indeed, those options would either morph

into options on the combined entity (larger company with lower volatility) if the deal was

conducted all in stock or it would settle right away (if the deal was in cash), thus destroying

all remaining time value in those options.

Further analyses on HomeAway options exhibit long term and short term implied volatility at

40ish (depending on strikes), thus not creating a negative carry differential. Moreover, recent

historical volatilities on HomeAway (6 months: 36, 1 year: 42) are also close to that mark.

Negative carry/time decay effect on long short term options would therefore be limited due to

natural idiosyncratic volatility.

Scenario II : Deal doesnt close and industry suffers from inability to reach critical mass

As mentioned before, in a difficult environment for deal making, Zillow and Trulia could see

their efforts to combine into an internet giant blocked by the FTC (or any othforer exogenous

factor not presently discussed). This turn of events would have repercussions on both Zillow and

Trulia but also would signal the current inability to consolidate the industry. It is our view that

only a dominant player will reap the benefits of scale and critical mass and therefore, such a

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signal would be extremely negative for the industry as a whole. To benefit from such a situation,

we would buy a series of puts, not only on Zillow and Trulia but also on a basket of publicly

traded competitors with tradable options. As already stressed out previously, implied volatility

on selected stocks appear reasonably priced in terms of implied volatility and therefore the

negative impact of time decay would not be too hurtful for our portfolio.

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APPENDIX I

Sources: Delayed quotes from the CBOE, http://www.cboe.com/DelayedQuote/QuoteTable.aspx

i. Illustration of a scenario where AWAY is being bid on December 3rd (1 month from today) at a 25% premium from current trading level.

ii. Positions have been entered into at market levels (mid-prices) as of November 3rd. iii. Implied volatilities are assumed to converge toward 20 after the bid (numbers could differ depending on the

acquirer, the structure of the deal etc. however volatility collapse is a common feature of merger announcements)

iv. Options valuations as of December 3rd have been computed using a simple Black & Scholes formula with no dividend and rates conditions prevalent at the time of writing.

i Kuchler, Hannah, Zillow to buy rival Trulia for $3.5bn, The Financial Times, July 28, 2014, http://www.ft.com/intl/cms/s/0/3f3cc922-166a-11e4-8210-00144feabdc0.html. ii Kendall, Brent and Joe Light, Review of Zillow-Trulia Merger Hinges on Advertising, The Wall Street Journal, Sept 8, 2014, http://online.wsj.com/articles/review-of-zillow-trulia-merger-hinges-on-home-sales-ad-pie-1410208093. iii Press Release: Zillow Announces Acquisition of Trulia for $3.5 Billion in Stock, July 28, 2014, http://investors.zillow.com/releasedetail.cfm?ReleaseID=862266. iv Kendall, Brent and Joe Light, Review of Zillow-Trulia Merger Hinges on Advertising, The Wall Street Journal, Sept 8, 2014, http://online.wsj.com/articles/review-of-zillow-trulia-merger-hinges-on-home-sales-ad-pie-1410208093. v Bubil, Harold, Realtors concerned about effects of Zillow-Trulia merger, Herald Tribune, July 29, 2014, http://www.heraldtribune.com/article/20140729/ARTICLE/140729670/-1/news?Title=Realtors-concerned-about-effects-of-Zillow-Trulia-merger&tc=ar. vi Zillow Quarterly Report for the Three Months Ended June 30, 2014, http://investors.zillow.com/secfiling.cfm?filingID=1193125-14-297610&CIK=1334814.

3-Nov-14AWAY $34.90

Position Maturity Type Strike ($) Strike (%) Price (Mkt) Volatility (%)1 16-Jan-15 Call 38.00$ 109% 1.40$ 43-1 20-Jan-17 Call 45.00$ 129% 4.90$ 38

Net Cash (3.50)$

3-Dec-14AWAY $43.63

Position Maturity Type Strike ($) Strike (%) Price (B&S) Volatility (%)1 16-Jan-15 Call 38.00$ 87% 5.64$ 20-1 20-Jan-17 Call 45.00$ 103% 4.71$ 20

Net Cash 0.93$

P&L (per spread) 4.43$

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vii Zillow Annual Report for 2013, February 18, 2014, http://investors.zillow.com/secfiling.cfm?filingID=1193125-14-568.00&CIK=1334814. viii Lardinois, Frederic, Move and National Association of Realtors Sue Zillow After It Poached Former President Of Realtor.com, TechCrunch, March 17, 2014, http://techcrunch.com/2014/03/17/move-and-national-association-of-realtors-sue-zillow-after-it-poached-former-president-of-realtor-com. ix Karkaria, Urvaksh, Atlantas Autotrader.com files for $300M IPO, Atlanta Business Journal, June 16, 2012, http://www.bizjournals.com/atlanta/blog/atlantech/2012/06/autotradercom-files-for-300m-ipo.html?page=all. x Alpert, Bill, Zillow Share Could Fall By Half, Barrons, August 9, 2014, http://online.barrons.com/articles/SB50001424053111904329504580071503076700616. Additional Works Consulted Crunchbase: Trulia, http://www.crunchbase.com/organization/trulia. Crunchbase: Zillow, http://www.crunchbase.com/organization/zillow. Garrison, Trey, Wall Street doesnt see antitrust hurdles for Zillows Trulia acquisition, HousingWire, July 30, 2014, http://www.housingwire.com/articles/30853-wall-street-doesnt-see-antitrust-hurdles-for-zillows-trulia-acquisition. Gopal, Prashant and John Gittelsohn, Zillow Topping Realogy Shows Web Surge for Housing Market, Bloomberg, July 30, 2014, http://www.bloomberg.com/news/2014-07-30/zillow-topping-realogy-shows-web-surge-for-housing-market.html. Inman, Brad, Zillow Plays to Win, inman, April 4, 2014, http://www.inman.com/2014/04/04/zillow-plays-to-win. Trulia Amended Annual Report for 2013, May 23, 2014, http://ir.trulia.com/phoenix.zhtml?c=251458&p=irol-sec&seccat01enhanced.1_rs=41&seccat01enhanced.1_rc=10&control_symbol=,#9480735. Zillow Annual Report for 2013, February 18, 2014, http://investors.zillow.com/secfiling.cfm?filingID=1193125-14-568.00&CIK=1334814. Zillow-Yahoo Partnership FAQ, October 12, 2012, http://www.zillow.com/wikipages/Zillow-Yahoo-Partnership-FAQ.