ZILLOW – TRULIA MERGER The Economist’s Case Study Challenge

SDA BOCCONI MBA TEAM MATTEO COLOMBO

TATIANA ZAKHAROVA

ATHINA PAPAIOANNOU

SDA BOCCONI SCHOOL OF MANAGEMENT

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Contents

Executive Summary ........................................................................................................................... 2

Introduction ........................................................................................................................................ 3

Business model of Zillow and Trulia ............................................................................................ 3

Industry overview ........................................................................................................................... 4

Question 1: Which company is getting a better deal and why? ..................................................... 5

Question 2: Does the structure of the deal make sense for each company? ................................. 7

Question 3: What will the futures likely to be for each company on a standalone basis if

transaction fails to close? ................................................................................................................... 8

Question 4: Based on the companies’ present combined market valuations, what assumptions

about their future would you have to make in order to buy stock in the combined company? 11

Question 5: What trades, if any, would you recommend around this transaction and why? ... 13

Appendix 1 ........................................................................................................................................ 14

Appendix 2 ........................................................................................................................................ 15

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Executive Summary

By mergering Zillow and Trulia, home sellers and real estate professionals will benefit from free

distribution of listings across even more platforms to reach a larger audience of consumers. Zillow

has more competitive advantages than Trulia in the transaction: it gains access to 74,000 paying

customers and a strong consumer brand with 51,6 mln of monthly unique visitors, as well as access

to the existing technical and marketing resources of Trulia. Trulia has taken the majority of the risks

in case the merger agreement is not successful. We expect that both companies on a standalone

basis will suffer from increasing competition in the online real estate marketplace, rapid change in

technologies and increasing dependence on large advertising budgets. The success of the merger

will depend on the ability of the companies to consolidate and expand their market share, the

improvement of the conversion rate of customers and exploitation of cost synergies. We

recommend a Buy position on Zillow and a Hold position for Trulia.

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Introduction

Business model of Zillow and Trulia

Zillow and Trulia follow very similar business models. They act as a real estate and home-related

information marketplace both through the mobile and Web interface serving homeowners, home

buyers, sellers, renters, real estate professionals, and lenders of all types.

To attract customers the companies employ different brands and products aimed to help people find

vital information about homes, rent, mortgages, rebuilding and connection with local professionals.

Zillow’s portfolio of brands includes Zillow.com, Zillow Mortgage Marketplace, Zillow Rentals,

Zillow Digs and Zillow Mobile. Trulia offers 15 mobile apps across multiple platforms. Zillow

highlights on its website that it is able to present homes not yet on the market. Trulia gives the user

the ability to learn about agents, neighbourhoods, schools, crime, and commute times. The database

is central to the value the companies provide to consumers and real estate professionals. Thus,

Zillow and Trulia are in the business of acquisition of current and accurate real estate listing data

from various third parties, including real estate listing aggregators, multiple listing services, real

estate brokerages, apartment management companies, and other third parties. By mergering Zillow

and Trulia, home sellers and their agents, brokerages, and participating multiple listing services

(MLSs) will benefit from seamless free distribution of listings across even more platforms to reach

an even larger audience of consumers.

Both Zillow and Trulia are primarily media companies, generating the majority of revenue through

sale of advertising products and services for real estate, rental, mortgage and home improvement

professionals. Neither company has anything to do with buying and selling homes.

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Industry overview

In the past, home buyers relied heavily on newspapers and newsstand real estate magazines to get

their home search started. Today, only 9% of prospective buyers, when polled by the National

Association of Realtors, responded that they would utilize newspaper ads and only 6% said they

would use the home books and magazines available at the newsstand, while 90% go online to

search for a house. Moreover the research showed that even the home buyers using agents still use

the Internet to supplement their home search. The majority of home buyers are still using real estate

agents, but they're utilizing online sources to conduct research and look for homes first.

Real estate agents have reacted well to the increased online presence in their business, getting more

involved with technology to meet changing consumer habits. However the market for residential

real estate transactions and home-related services is highly fragmented and local. Real estate

professionals are still heavily relying on local newspapers, television, magazines, and

home/apartment guide publications to advertise their qualifications or listings.

The success in the industry depends on how fast advertising dollars migrate online from traditional

broadcast and print media. In accordance with expert estimations, real estate professionals spend

$12 billion on marketing their services each year. We estimated that the combined revenue of

Zillow and Trulia for 2014 will represent only 5% of total advertising budgets of real estate agents

(see chart 1 in appendix 1 for the calculation of estimated revenues for 2014).

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Question 1: Which company is getting a better deal and why?

Zillow and Trulia are the top two online real estate companies in the US. While operating very

similar business models and closely following each other through the various development stages,

the two companies showed different results in terms of financial performance.

Zillow’s revenue for 2013 amounted to $198 mln in comparison with $144 mln of Trulia (see chart

1 in appendix 1). Although both companies had a very close number of paying customers (see chart

2 in appendix 1), Zillow is able to extract more value from its advertisers who payed, in Q2 of 2014,

$320 of average monthly revenue per agent in comparison with $206 of Trulia. This helps to

explain a compound annual revenue growth of 62,8% over the last 6 years for Zillow. Trulia on the

other hand, has been weaker in terms of revenue growth. However, acquisition of a Market Leader

in 2013 helped to boost revenues by almost 110% in 2013 in comparison with 2012. As a result

Trulia overtook Zillow in the number of paying customers in 2013.

In our opinion, Zillow will have more competitive advantages than Trulia in completing the

transaction. In an industry where revenue growth is determined by the ability to acquire real estate

professionals and convert them into paying customers, Zillow will gain access to almost 74,000

paying customers and a strong consumer brand with 51,6 mln of monthly unique visitors by the end

of Q2 of 2014 across websites and mobile devices (see chart 2 and 3 in appendix 1). With limited

consumer overlap the newly formed Zillow will have more market share and significant

opportunities for scale. In acquiring more unique users, the web space owned by each company has

more leverage to demand higher advertising fees, which increases future revenue growth.

Future value creation highly depends on the ability to expand the platform beyond advertising

services for real estate professionals by developing additional marketing and business technology

solutions to help those professionals manage and grow their businesses and personal brands. Zillow

enhances its technological and marketing competencies by acquiring companies and integrating

them: during the period from 2011 to 2014 Zillow acquired seven companies. The deal allows

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Zillow not only to gain access to the existing technical and marketing resources of Trulia, but also

significantly strengthens Zillow’s competencies and capabilities required for product and business

development in the future, while being able to integrate Trulia quickly and efficiently.

Finally, the combined company will be managed by the existing Zillow CEO, Spencer Rascoff.

Even if both brands will be kept and Trulia CEO, Pete Flint, will remain in his chair, the decision-

making power of Trulia will be reduced and the strategic objectives and future development of the

company will be mainly determined by Zillow’s top management.

The legal structure of the deal also gives Zillow a strong competitive advantage, compared to

Trulia, allowing the company to significantly reduce its own risks if the merger fails on antitrust

grounds. Please refer to question 2 for more details.

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Question 2: Does the structure of the deal make sense for each company?

On July 28, 2014, Zillow announced that it has entered into a definitive agreement to acquire Trulia

for $3.5 billion in a stock-for-stock transaction. As part of the agreement, Trulia shareholders will

receive 0.444 shares of Class A Common Stock of Zillow for each share of Trulia, and will own

approximately 33% of the combined company at closing. Current Zillow holders of Class A

Common Stock and Class B Common Stock will receive one comparable share of the combined

company at closing, and will represent approximately 67% of the combined company. The value of

the deal represents a premium of 30% to Trulia's closing price on July 25, 2014.

The merger is subject to the satisfaction of customary closing conditions, including the expiration of

U.S. antitrust waiting periods and shareholder approval of both companies.

In our opinion, Trulia has taken the majority of the risks in case the merger agreement is not

successful. First of all, the acquisition agreement can stay in effect till January 28, 2016 (almost 18

month after the announcement). Trulia can not make acquisitions, capital expenditures or borrow

money without Zillow’s approval. Trulia cannot enter into an employment agreement involving

compensation higher than $275,000, and cannot begin any intellectual property actions. Secondly, if

the authorities disagree and impose any type of restriction on the deal, even minor restrictions,

Zillow can walk away and pay a $150 million termination fee. It is highly uncertain whether this

amount would compensate Trulia for the time and expense of being left to wait for up to 18 months.

In addition to what has been stated above, we assume that Zillow’s stock was overvalued.

Consequently, they may have a greater incentive to make a stock-for-stock transaction and use the

overvalued equity to purchase Trulia’s assets at an effective discount. In reality, the stock price of

Zillow fell by 7% the day after the announcement and lost around 50% of its value in the 3 month

period after the announcement.

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Question 3: What will the futures likely to be for each company on a standalone

basis if transaction fails to close?

The business prospects of Zillow and Trulia on a standalone basis are highly depending on the

following:

the ability to attract real estate professionals and convert them into paying subscribers. The

current market penetration of the companies is low. Trulia reported that it was able to attract

669 thousand real estate professionals out of a total 2,8 million in the US as of 30 June 2014.

However, only 11% of these active customers are paying for their subscription. In a highly

fragmented and highly competitive market both companies will continue to struggle with the

number of real estate professionals subscribing to their products. Moreover, it is highly unlikely

that the companies on a standalone basis will be able to significantly increase their revenues

from advertisers. Although Zillow is able to extract more value from its customers and charge

$320 of monthly average revenue per agent, this number was increased by only 55% in a 2,5

year period from Q1 2011 to Q2 2014. So, we expect lower revenue growth for both companies

in the nearest future. The companies may seek to compensate their subscription-based revenue

by other marketplace revenue. We have acknowledged that a share of Zillow’s revenue from its

Premier Agent advertisers decreased from 92% of total marketplace revenue in 2011 to 86% in

6 months of 2014 (see table 1 in appendix 2). However, the decrease of subscription-based

revenue will lead to greater volatility of revenues and higher risks for investors.

brand awareness among consumers and real estate professionals and the ability to attract home

owners using websites and mobile applications with moderate spending on development,

marketing and hiring of new employees. Zillow increased its sales and marketing expenses by

122% in 2013 in comparison with 2012 and Trulia by 111% for the same period (see table 1 in

appendix 2). Both companies currently spend more than 50% of their revenues on advertising

and marketing. Increasing competition in the industry will require even heavier adverting

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budgets that, considering the possibility of stabilized revenues, will further undermine the

ability of both companies to turn a profit.

Currently Trulia seems much weaker in terms of financial performance and the ability to generate

and sustain revenue growth compared with Zillow. The company's weaknesses can be seen in

multiple areas, such as its increasing net operating loss, losing momentum in organic revenue

growth and difficulty in increasing average revenue per subscriber, inability to effectively integrate

acquired business of Market Leader. Growth rates of monthly unique visitors has decreased on a

year-over-year basis from 52% in Q1 2013 to 37% in Q1 2014 meaning that increasing marketing

and advertising expenses doesnt generate additional consumer traffic. Future business growth

depends also on the ability to attract financing. In December 2013 Trulia issued $230.0 million

aggregate principal amount of 2.75% Convertible Senior Notes, due in 2020. Trulia doesn’t have

experience of seasonal offerings. Taken into consideration the financial situation of the company

described above its ability to raise funds on equity or capital markets in the future is highly

questionable. Moreover, a failed merger with Zillow will negatively affect the business of Trulia, its

operating results and image.

Zillow seems to have a more robust marketplace platform that enabled the company to grow its

business more quickly and efficiently over the last years. It demonstrated the ability to seize

strategic opportunities, including expansion of business into adjacent markets, such as rentals and

mortgages, commercial relationships and acquisitions. In February 2011, Zillow launched a

strategic relationship with Yahoo! Real Estate. During the period from 2011 to 2014 Zillow

acquired seven companies. Zillow also has an ability to secure funds to finance its growth and

acquisitions. Being a debt free company, Zillow went twice to the market for the seasonal offerings

after the IPO in 2011. However, as for Trulia, we foresee difficulties the company will need to face

in providing sustainable growth of revenues and improving operating efficiency. The revenue

growth is still high but flat at an average year-over-year level of 70% during the last four quarters.

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This is maily due to the decreasing growth rate of paying subscribers: 46% in Q2 of 2014 on year-

over-year basis in comparison with 71% in Q2 of 2013. Heavy marketing expenses created only

49% of year-over-year growth of monthly unique visitors in Q2 of 2014 and resulted in deteriorated

net operating results in 2013 and in the 6 months in 2014.

To conclude, we expect that both companies on a standalone basis will suffer from increasing

competition in the online real estate marketplace, rapid change in mobile and Internet technologies

and increasing dependence on large advertising budgets. This may lead to decrease of market share

of each of the companies, weakening of their brands, inability to create value for advertisers and

deteriorating of financial results.

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Question 4: Based on the companies’ present combined market valuations, what

assumptions about their future would you have to make in order to buy stock in

the combined company?

Assuming the regulator allows the merger, in order to invest in the combined company we need to

assume that there is real value creation from the transaction and not simply an extraction of value

from one side against the other. Considering the high similarity of the two companies’ business

models, we expect that the integration will be strong on everything that the final user does not see

but also soft and “consensus driven” to keep Trulia’s core competencies which lie in its people.

Considering the revenue side of merger, investors are willing to buy the stock if the compounded

average revenue growth rate is at least equal to or higher in the last 3 years, 44% for Zillow and

55% for Trulia (50% considering only organic growth). Typically, in the early stage of high-tech

young fast growing companies the revenue growth and their projections are the key drivers of value.

The market growth is highly correlated to both the speed the advertisers will move from traditional

offline advertising to the online one and the overall situation of the real estate market in the US.

While the first trend is reasonably guaranteed by the inexorably increase in connected users, we

need to assume that the real estate market in the US will continue to stably improve guaranteeing

high demand and high supply, without enhancing a new housing bubble.

More specifically, the revenue growth drivers are the increasing unique visitors population, which

attracts real estate agent advertisers as paying subscribers. Given the trends stated above, while the

market will grow constantly, the market share improvement should be critical for the new entity in

order to prevent easy entrance of new players or the growth of the smaller existing ones. If the

regulator will not introduce limitations to the freedom of the Zillow & Trulia merger we assume

that they will succeed in consolidating and expanding their market share, locking in their existing

paying customers. The improvements in conversion rate of customers into paying subscribers are

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achieved under the assumption that Trulia’s marketing and customer focus capabilities are shared

with Zillow and that the combined marketing budget is exploited more efficiently.

In the short term the absorption of Trulia’s brand into Zillow’s one could damage their overall

revenues due to the loss of shared visitors and consequently of overlapping paying customers.

On the costs side, we should assume that the 100 USD Mil savings declared are actually achieved

through optimized advisement budgets, economies of scale in managing a higher number of MLS

and continuous technology and service development synergies.

As investors we would bet on the future of the merger if we assume that the current fragmented

market will consolidate following Zillow’s example in order to increase the customer base and the

bargaining power with subscribers but also optimising their pricing strategy. Thus, Zillow will gain

a first mover competitive advantage.

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Question 5: What trades, if any, would you recommend around this transaction

and why?

Giving the current status of the transaction and the analysis above, we believe that the consolidation

is the natural evolution of the market and thus there is a good chance that the regulator will approve

the transaction. Indeed new incumbents from the high-tech industry are close to entering the market,

for example Google, with service for real estate professionals leveraging its leadership in internet

usage and customer data acquisition.

In conclusion we would recommend a Buy position on Zillow because they retain a better position

in the deal to capture the synergies while having limited exposure to risks related to authority and

transaction structure which are run mostly by Trulia. Following this consideration we would

recommend a Hold position for Trulia which reflects a positive position about the merger but also

considers their additional exposure to the potentially weaker part of the deal.

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Appendix 1

Chart 1: Revenues for 2008 – 2014*, in million of US dollars

* The estimated revenues for 2014 was calculated based on revenue for 6 months period ended 30 June 2014 adopting the assumption that in 6 months

ended 31 December 2014 the revenues will increase by 15% due to seasonality of business

Chart 2: Paying subscribers in the period from Q1 of 2011 to Q2 of 2014, in thousand

Chart 3: Unique monthly visitors in the period from Q1 of 2011 to Q2 of 2014, in million

10,6 17,5 30,5

66,1

116,9

197,5

333,3

8,1 10,3 19,8 38,5

68,1

143,7

272,7

2008 2009 2010 2011 2012 2013 2014E

Zillow Trulia

11 13 15 16 19 23

27 29 34

39 45 48

53

12 15 17 17 20 22 23 24 28

32

57 60

67

q2'11 q3'11 q4'11 q1'12 q2'12 q3'12 q4'12 q1'13 q2'13 q3'13 q4'13 q1'14 q2'14

Zillow Trulia

17 21

24 24

32 33 36 35

47 54

61 54

71

81

12 15 17 16 21 24 25 24

31 35

41 34

43

52

q1'11 q2'11 q3'11 q4'11 q1'12 q2'12 q3'12 q4'12 q1'13 q2'13 q3'13 q4'13 q1'14 q2'14

Zillow Trulia

Zillow

CAGR ’08-’13: 62,8%

CAGR ’11-’13: 44.0%

Trulia

CAGR ’08-’13: 61,5%

CAGR ’11-’13: 55,1%

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Appendix 2

Table 1: Composition of revenue and expenses for 2008 – 2013

2008 2009 2010 2011 2012 2013 6m 2014

Zillow

Revenue 10.593 17.491 30.467 66.053 116.850 197.545 144.918

Marketplace revenue 130 3.912 13.228 42.190 86.670 154.208 116.340

% of tot. 1% 22% 43% 64% 74% 78% 80%

of which Subscription-based revenue* nd nd nd 39.003 77.832 132.130 99.992

% of marketplace revenue, % nd nd nd 92% 90% 86% 86%

Display revenue 10.463 13.579 17.239 23.863 30.180 43.337 28.578

% of tot. 99% 78% 57% 36% 26% 22% 20%

Total costs and expenses 32.497 30.457 37.304 65.056 111.053 214.494 162.157

Sales and marketing 7.481 9.654 14.996 25.725 49.105 108.891 82.973

% of revenue 71% 55% 49% 39% 42% 55% 57%

Y-t-Y growth, % 29% 55% 72% 91% 122% na

Trulia

Revenue 8.066 10.338 19.785 38.518 68.085 143.728 118.575

Marketplace revenue nd nd nd nd 47.805 113.383 nd

% of tot. nd nd nd nd 70% 79% nd

of which Subscription-based revenue* nd nd nd nd 40.196 100.757 nd

% of marketplace revenue, % nd nd nd nd 84% 89% nd

Display revenue nd nd nd nd 20.280 30.345 nd

% of tot. nd nd nd nd 30% 21% nd

Total costs and expenses 13.807 17.355 23.599 44.285 77.604 167.871 147.886

Sales and marketing 5.194 5.532 8.638 17.717 33.747 71.370 70.647

% of revenue 64% 54% 44% 46% 50% 50% 60%

Y-t-Y growth, % 7% 56% 105% 90% 111% na

*subscription-based revenue was calculated by multiplying the number of subscribers by monthly ARPA and by number of months in the period