Tuesday, August 12, 2014

* Zillow (Z) - Misrepresenting User Base? Is Option Market Under-pricing Risk... By a Lot?

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Z is trading $132.63, down 2.3% with IV30™ down 1.0%. The Symbol Summary is included below.

Provided by Livevol

I need to start with this disclosure:
  • The hedge fund is naked short Zillow.
  • We opened the position before this blog (weeks before).
  • I do not give advice, am not registered or licensed to give advice and nothing on this blog should ever be construed as a solicitation to buy or sell any security ever.
  • We're wrong a lot.

Our opinion on Zillow is based mostly upon the quantitative model I created called the Forensic Alpha Model (FAM). Everybody has a quant model (although not everybody gets published in the Rotman International Journal; yeah, that Rotman). I will not link to the research because I'm not soliciting it -- you can Google it if you have the inclination.

The risk in the stock price as reflected by the option market is quite low relative to the company's past.  My contention, stock up or down, is that the volatility may be too low... or in English, the stock may move more than the option market reflects.

The catalyst to writing about Z actually came from an article just posted on Yahoo! Finance. Here it is:
When Zillow reported second quarter results last week, the company highlighted in its press release that it achieved record all time traffic during the quarter of 89 million unique users in July, a 45% y/y increase. That sounds great, except that when you step back for a moment and really think about that number, it doesn’t make a whole lot of sense.

Zillow only covers the US real estate market, and there are only 121 million households in the US, which means that if Zillow really had 89 million monthly unique users, 74% of all US households would be visiting Zillow every single month. Moreover, existing home sales are currently only running at about a 5m unit annual pace. Are 18x that many people really using Zillow each month? Even Twitter claims fewer monthly unique users in the US than Zillow, and Facebook claims just 2.3x more.


Sure enough if you look at Zillow’s 10-K or Q, they imply that the monthly unique data probably overstates its user count.

Source: Is Zillow overstating the size of its user base?

Let's start with the two-year stock chart.

Provided by Charles Schwab optionsXpress

Z is up 245% over two-years, so it has returned huge for long equity holders.  The traffic number to the site is not the most critical part of this firm in-and-of-itself.

From Zillow

Zillow provides various advertising products and services, including Premier Agent program, which offers a suite of marketing and business technology solutions for real estate agents; Zillow Mortgage Marketplace, where borrowers connect with lenders to find loans and get mortgage rates; Zillow Rentals, a marketplace and suite of tools for rental professionals, Postlets, Diverse Solutions, Agentfolio, Mortech, HotPads, and StreetEasy; and graphical mobile and Web advertising services on its home page and on individual Web pages.

The point is, more traffic should be more money, but the business is not simply based on 'page views' or whatever for web ads. It's much more than that (right?).

Ok, now let's turn to the IV30™ chart in isolation, below.

Provided by Livevol

The implied volatility is the forward looking risk in the equity price as reflected by the option market (IV30™ looks forward exactly 30 calendar days).

In English, the red curve is the risk in future stock price movement. We can see (that little yellow circle) that the risk in the stock price as reflected by the option market is quite low relative to the company's past.  My contention, stock up or down, is that the volatility may be too low... or in English, the stock may move more than the option market reflects.

Let's look to some financial measures.

Revenue for Z has looked like this for the last four quarters:
  • $66M
  • $58M
  • $53M
  • $43M

So that's ~50% growth last quarter to four quarters ago. That's serious growth (regardless of a stock valuation).

The company does have substantial cash on hand at $154M as of 3-31-2014.

But... then there's this...

One of my favorite measures is Operating Revenue / Operating Expenses. This ratio needs to be above 1.0 (i.e. Revenue > Expenses) at the very least for a firm to turn a profit.

Provided by Capital Market Laboratories

We can see Z barely hit that minimum threshold a few quarters ago, but the trend... it ain't pretty. But... this firm actually has turned a profit before -- I'm talking about Net Income / bottom line / real profit.

Another measure I like to look at with these firms is their SG&A relative to Op Ex.

Provided by Capital Market Laboratories

Zillow needs to spend to get users / customers. That spend comes in selling, general & administrative expenses (SG&A). We can see the firm's spend relative to other expenses is increasing rather dramatically. That doesn't mean it's bad or good, it just means it is rising.

I don't like either of those trends and I really don't like a $5.3B market cap.

Here's the the take from Barron's, recently:

Zillow trades at 20 times sales and will lose money this year, Bill observes. The sites don’t seem to have much heft in the real estate industry in a strong climate where brokers can lure their own prospects. The companies are probably worth “just a few billion dollars” rather than the combined $8 billion they trade for now.

Source: Barron's via Yahoo! Finance Zillow Slips on Negative Barron’s Article, written by Tiernan Ray.

Finally, the Options Tab is included below.

Provided by Livevol

Using the at-the-money (ATM) straddle we can see that the option market reflects a price range of [$112, $148] by the end of trading on Sep 19th.

  • If you believe the stock will be outside that range on expiry or any date before then, then you think the volatility is too low.
  • If you believe that range is too wide, and that the stock will definitively be in that range on expiration, then you think volatility is too high.
  • If you're not sure, and can make an argument for either case, then you think volatility is priced just about right.

I believe the stock will move more than that range, but I have no option positions and intend to make no option trades before Sep. My opinion is rather empty anyway since it's... just my opinion, but this one doesn't even come with a position.

I think Z is in for a ride before Sep 19th.  While the hedge fund is betting down, relative to the options, I think vol is a bit low.

This is trade analysis, not a recommendation.

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