Zillow (Nasdaq:Z) announced August 19 that it was acquiring StreetEasy, a New York-area real estate website, for $50 million. That isn't a lot of money for a company with a $3 billion market cap. However, Zillow sees the move as critical to its success in New York City, the nation's largest real estate market.
Is this a game changer? Should you buy its stock based on this news? Read on and I'll tell you.
On a day when the markets were relatively flat—S&P 500 down 0.29%—Zillow lost 7% of its value during unusually heavy trading. Investor reaction seems quite negative and overdone considering the good things it had to say about StreetEasy in its press release. There has to be more to Zillow's decline…and there is.
At the same time it announced its StreetEasy acquisition it also indicated it was selling 2.5 million shares to investors at $82 per share, a 10% discount to its August 16 closing price. In addition, existing shareholders were selling slightly more than 2.5 million of their stock as well at the 10% discount. The $205 milliion in gross proceeds will be used to pay for its acquisition and to fund future investments and working capital.
SEE: What is a tuck-in acquisition?
In addition to the share issue, RBC Capital Markets downgraded Trulia (NYSE:TRLA), Zillow's biggest rival, from "Outperform" to "Sector Perform" August 19 due to valuation concerns. Zillow fell in reaction to the Trulia news. RBC also did the same thing (downgrade from outperform to sector perform) to Zillow August 7. Interestingly, while RBC cut the stock's rating, it simultaneously raised its target price to $90 from $64, causing Zillow's stock to temporarily jump above $97. It's since fallen back.
What Street Easy Brings
Goldman Sachs (NYSE:GS) analyst Heath Terry expects Zillow to provide StreetEasy with additional product development resources and greater monetization options in the mobile realm. StreetEasy brings 10 times the listings of Zillow in the NYC-area and 1.2 million monthly unique visitors. Zillow CEO Spencer Rascoff has this to say about the deal: "StreetEasy is an incredibly strong and recognized brand in New York City…Simply put, StreetEasy has cracked the code in New York. They now have a local network effect where nearly every New York broker is active on StreetEasy because of the site's large audience and comprehensive data."
I don't know how many listings Trulia has in New York City but I doubt it's anywhere near Zillow's total; StreetEasy makes it an absolute rout.
SEE: Why You Don't Need A Real Estate Agent
RBC has a problem with Zillow and Trulia's valuations. Its target price for both companies are $90 and $47 respectively. That puts Zillow's 12-month market cap at $3.14 billion versus $1.53 billion for Trulia. Analysts estimate Zillow's 2014 earnings will be $0.55 per share; Trulia's at $0.73. Zillow is currently trading at 154 times future earnings compared to 60 times for Trulia. That puts Zillow's PEG ratio at 5.1 compared to 3.0 for Trulia. On that basis if you were going to pick one of the stocks to acquire it would have to be Trulia—at least from that perspective anyway.
It's hard to imagine that purchasing a $50 million business could be the difference between Zillow's ultimate success or failure. Nonetheless, if you want to win the hearts and minds of Americans, you often have to go through New York, Los Angeles and Chicago to do it. And while it's not incomprehensible that Trulia would be able to catch up to a combined Zillow/StreetEasy in the New York City area—it's highly unlikely. Trulia will therefore have to capture one or both of the other markets in order to remain competitive. It's a tall order in my opinion.
Zillow's CEO considers his company a media business whose success depends entirely on the size of its audience and the number of eyeballs visiting on a regular basis. The bigger the better; that's why the StreetEasy acquisition makes so much sense. It brings to the table a huge audience that would have taken Zillow far longer to cultivate on its own.
Real estate agents annually spend between $6 billion and $10 billion on advertising. Zillow, which is by far the biggest real estate website in America, gets only 3% of that money. Considering what's happening in mobile you have to like the opportunity sitting right in front of it. If Zillow continues to make smart acquisitions like the one it just made for StreetEasy it won't be long before the real profits start rolling in.
The residential real estate market is finally heating up. Tri Pointe Homes (NYSE:TPH) and several other homebuilders have gone public in 2013; even Re/Max is contemplating an IPO. Zillow and Trulia are in the middle of all of it. You have to like the chances of one or both of them succeeding in a big way as a result.
Should you own Zillow stock based on the StreetEasy news?
I think it certainly helps push undecided investors in that direction. However, a lot's going to happen between today and five years from now. It's almost impossible to handicap. That said, I see Zillow in a very formidable position thanks to the StreetEasy acquisition. I'd buy its stock but only with the understanding that it's not going to represent more than 2%-3% of your overall investment portfolio.
Disclosure - At the time of writing, the author did not own shares of any company mentioned in this article.