Description

We believe the recent IPO of Zoopla represents a timely and compelling short idea that we expect will play out within the next 6 to 9 months. The idea is fairly simple and we’ll therefore try to keep the write up as short as possible. There are a number of sell side analysts that recently initiated on the stock – I would suggest reader to get hold of one of these reports for background information.

We believe Zoopla share price has c. 30% downside in a base case scenario and over 60% downside in a negative scenario with very upside in what we believe to be a best case scenario. The investment thesis is very simple: the market is completely disregarding the risks associated with a new competitor that will launch in January 2015 that and disrupt what has been traditionally a very comfy duopoly between Zoopla and Rightmove.

About the business

Zoopla is an online portal for real estate listings. For US VIC readers, it could be compared to Zillow / Trulia but as explained below, there are numerous differences. The business model is fundamentally simple. Zoopla charges a monthly fee to real estate agents to be able to list their properties on the website. Agents can also purchase premium type of services that would enhance their visibility within the website. For the financial year end September 2014, approximately 79% of total revenues wil come from subscription revenues from estate agents. The rest is either pure media / advertising revenues (c. 12% of total) or from subscription revenues from homebuilders that want to advertise their new homes on the website. The business is almost identical to its more established competitor Rightmove (RMV).

Zoopla is a high quality business where barriers to entry appear high (in an established duopoly), pricing power is strong (ARPA – Average Revenue Per Agent, indicated per month) with annual price inflation in the mid to high teens, visibility is high with almost 90% of revenues being recurring based on subscription and churn (undisclosed) is very low. Rightmove historically traded at 25-30x P/E forward to reflect such desirable business characteristics and the equivalent company in Australia, REA Group, currently trades above 30x forward. The business is extremely cash generative with minimal capex requirement and margins are very high. Zoopla expected EBIT margin in 2014 will be c. 42%, which is nice but still well below the 74% expected from Rightmove. Incidentally, this margin discrepancy is one of the tenets of the bull case on Zoopla.

Looking at TAM and market share, in 2014, the UK Property Classified Advertising Spend is expected to be £427m according to Enders Analysis as reported in IPO prospectus. Approximately £230m, or c. 54%, will be spent in online advertising. Zoopla and Rightmove represent the vast majority of this market. Adding up expected 2014 agents revenues from the two, we get to over 90% of TAM suggesting that the market is already highly penetrated and further market gains will need to come from a) rebound in advertising expenditure as residential market recovers in the UK and, b) online spending taking market share from print. In terms of number of agents, excluding developers, Zoopla has c. 16,500 agents signed up which is very similar to Rightmove number of agents. It is estimated that the UK market has c. 18-19,000 real estate agents so penetration is c. 90% for Zoopla. According to management, the other 10% is not “unpenetrated” but in most cases comprises agents that have only 1 subscription between Rightmove and Zoopla. In other words, there are very few agents left in the UK that don’t have subscription to any portal. This is clearly important because it means that all growth will have to come from pricing power.

Comparing UK Vs. US Market

For those investors unfamiliar with UK residential market, a quick comparison with the US market would probably help. Listing portals are fundamental in the UK because they represent the only place a buyer can find virtually all listings. Unlike the US where any listing is given to an MLS and then syndicated nationally, there is no MLS as such in the UK. For this reason, whilst content in the US is a commodity and a prospective buyer could find the same property on many different websites, prospective buyers in the UK have only 2 options when looking to purchase a new property: they can either go to many estate agents or simply go on Zoopla / Rightmove where virtually all listings are present.

Therefore, whilst an agent in the US doesn’t need to be on Zillow / Trulia, it’s just a marketing channel but not a “must have”, a UK agent has to be on it or else it will lose clients. A vendor will simply not give his home to sell to an agent that doesn’t have either Rightmove or Zoopla (or both) because he or she will likely miss potential buyers. Finally, Zillow / Trulia are really designed for agents acting as buyers, not sellers. In the US, there are 2 commission sides, in the UK only the seller gets paid. Advertisers on Zoopla and Rightmove are doing it because they have to be on it not to lose mandates but it’s not a “customer acquisition” marketing function. Yes – some agents advertise on Zoopla / Rightmove so they can build some brand recognition but at the end of the day, studies show how the vast majority of vendors choose their agents based on referrals, reputation or simply location. A vendor will not go online to choose which agent to appoint. Furthermore, the vast majority (above 90%)  of mandates are exclusive so an agent will “gain” a potential sell mandate online only on those non-exclusive sales where he may gain a slight advantage over another agent by being higher up in the listings on Zoopla and Rightmove.

In summary: Zillow / Trulia are marketing channels for agents and good website for customers. Rightmove and Zoopla are “necessary costs” for agents and a must for customers as the only place to find all listings. It follows something very important that sell side currently misunderstands. Whilst in the US there is a huge ongoing debate about perceived dominance of Zulia, friends or foe etc., at the end of the day, some agents are very happy to have them as they are winning market share and others aren’t so happy, but ultimately, those that use Zillow or Trulia are happy to pay up since the (perceived?) ROI is greater than 1. In the UK, virtually all agents hate Rightmove and Zoopla because they don't really generate any business for them. On the contrary, they are being seen as dis-intermediated by those portals that extract an increasingly higher percentage of their commission pool. It’s a necessary evil for UK agents. This is something crucial to our thesis.

Zoopla vs. Rightmove and the Bull case

We thought important to compare Zoopla, the contender, to Rightmove, the established incumbent, because this is the essence of the bull case: Rightmove is today what Zoopla will be in a couple of years. Both portals have similar number of agents on (c. 16-17k) but Rightmove EBIT this year will be c. £120m while Zoopla’s will be below £40m. There are 2 main reasons for this:

1. Rightmove ARPA in 2014 will be c. £680 compared to Zoopla’s c. £315
2. Rightmove EBIT margins are in excess of 70% Vs Zoopla in the 40s

Bulls assign a very high valuation to Zoopla because Zoopla will bridge the gap on both metrics for the following reasons:

1. Zoopla lower ARPA reflects the fact that it started from lower base, it was the less established player and it is playing catch up with Rightmove from viewership perspective. This will translate in better monetisation of agents
2. Zoopla overspent in marketing in recent years to establish its own brand. Marketing spend will decrease significantly lifting margins considerably

Catch up with Rightmove will lead to higher sales and profit growth trajectory which in turns will justify a higher valuation. From UBS initiation from August 5^th: “ZPG trades on 32x calendarised 2015E PE, a 30% premium to Rightmove and REA Group. We believe this premium is justified given that we forecast ZPG to deliver higher growth, with FY14-18E sales CAGR of 15% and EPS CAGR of 27%”.

Bear thesis – Agents’ Mutual

Enter Onthemarket.co.uk. As discussed above, UK agents don’t like online portals for a number of reasons:

• They are perceived as cost centres for them, not marketing spending that will generate more leads
• Agents hate losing control of their listings
• Agents are tired of seeing their fees being put up 15-20% a year
• Traditional brick & mortar agents absolutely despise online agents that undercut them on fees. Online agents effectively exist only thanks to Rightmove and Zoopla

Many agents therefore started looking for alternatives. Some agents like Countrywide (the largest in the UK) decided to create their own portal and invest marketing dollar there instead of Rightmove / Zoopla (CWD used to spend the vast majority of its marketing on Rightmove, now it is equally balanced between RMV / ZPLA and its own website). Countrywide could rely on its own website (Propertywide.co.uk) because it has enough scale to do so. Other smaller agents couldn’t do that.

Some of the leading estate and lettings agents in the UK have therefore decided to found Agents’ Mutual (“AM”) in order to create a new industry-owned property portal, which intends to launch in January 2015 and will be called Onthemarket.co.uk. The founding members of Agents’ Mutual are Savills, Knight Frank, Strutt & Parker, Chesterton Humberts, Douglas & Gordon and Glentree Estates (together representing 240 branches as at 31 March 2014). Agents’ Mutual’s information memorandum dated 26 July 2013 states that it will require its members to list on Agents’ Mutual’s website and a maximum of one other property portal of its members’ choosing. In May 2014, Agents’ Mutual claimed at an industry presentation to have signed up approximately 550 member firms representing 1,850 branches.

Also in May 2014, the CEO of Agents Mutual said “we now have £6m capital in place in order to move to implementation and plan to launch the new website in January 2015. Approximately 2,000 estate agents have already signed up, many more have expressed an interest in joining and support appears to be building in all areas across the country”. On Agents’ Mutual website today it lists amongst the 10 reasons to join it, as point #4: “Over 900 members with 3,000 offices, including national firms, but more than 78% have between one and three offices”. Finally, on July 22nd, the CEO announced that they crossed 3k members and the next milestone would be 4k and at that point they will change letters of intent into binding contracts for its new Silver and Gold members. The aim is to have 5k members by the time they launch in January 2015. Based on these figures, it looks like the group is currently adding 4-500 estate agents every month so we think the 5k target for day 1 launch is achievable.

The most important elements in Agents Mutual offering are the following:

•             100% agent-owned and agent-controlled

•             Opportunity to fix listing fees for 5 years at a very low level

•             Similar scale (they hope) to Rightmove but charged to agents at cost

•             Launching January 2015

•             Allows agent to list only in 1 other online portal

Pricing is not yet fully disclosed but ARPA is expected to be in the £300-400 range, i.e. in line with Zoopla but well below Rightmove. It’s important to remind ourselves why agents are doing this: they are not trying to save a buck to have a lower fee on their portal, they want to break the current duopoly which, in the future, may significantly impact the way they currently do business. We suggest the reader to check out a couple of blogs online to gauge the animosity felt by the agents towards Rightmove and Zoopla.

Our base case scenario assumes Agent’s Mutual will launch. The next milestone is reaching 4,000 agents which we expect to happen in October. Once this happens, letters of intent will be formalised into binding contracts and there will be no way back. We are assuming that on day one, on January 1^st 2015, 4,000 new agents will leave either Rightmove or Zoopla to join Agents’ Mutual. The street (i.e. the brokers involved in the IPO) is quick to minimise the impact from Agents Mutual. They all assume it will fail, eventually. The arguments are pretty well known: AM will be too small, they won’t have enough inventory to attract consumers, their brand is unknown to the market, previous attempts to enter the market (e.g. Newscorp with Globrix) miserably failed, their marketing budget will be too low and many more. To all these arguments, we’d like to answer very simply: it doesn’t matter. We are not banking on the fact that AM will be a successful business and reach the size of RMV or the size of Zoopla. We are not saying it will achieve higher margins. As far as we are concerned, AM will be a success if it will be able to generate zero EBIT margin in 3 years from now. After all, this is not a profit centre for agents, it’s not a for-profit business but a mutual. It is a way for agents to break the duopoly and its “success” will not be measured in terms of achieved EBITDA margin. Its mere existence disrupting the status quo will be a success. The impact to the industry cannot bet understated. Given the exclusivity rule (i.e. AM agents can list only either in Rightmove or Zoopla, but not both), what AM will cause is a market where there won’t be any single site including all listings. Buyers will have to go to 3 portals to make sure they have seen all listings. Today, a buyer can just go on Rightmove and he or she will be sure to find any home that is actually for sale. This will no longer be true the second AM is launched and this will dramatically reduce Zoopla current pricing power.

The only real argument, in our opinion, against Agents Mutual is that it simply won’t take off because in the end, the risk for agents leaving Rightmove / Zoopla will just be too big. We agree this is THE single biggest risk to our short thesis but we think there is an important mitigating factor here. It would be suicidal for an agent to drop both Rightmove and Zoopla as vendors will simply not give them the mandate. However, we think it will be very unlikely for a vendor to turn to an agent and say “hey, I am not giving you my home to sell because you are on Rightmove and on AM and not on Zoopla”. As long as the property is listed on an established portal, the vendor should be happy with this. This is consistent with conversations we had with a number of industry participants.

Agents’ Mutual impact and Valuation considerations

In our base case scenario, we are assuming Agents Mutual will launch with 4,000 agents. We believe the vast majority (75%) of these will come from Zoopla for a very simple reason: Rightmove is the “must have” portal being the most established one,  so the less risky action for an agent wanting to move to AM would be to drop Zoopla. This is consistent with what we heard from our industry sources. We therefore assume in our model a net reduction of 3,000 agents. This would represent c. 18% of the agent base. Note that sell-side analyst are nowhere near those numbers. The net change in number of agents assumed for 2015 is the following:

• UBS – loss of 750 agents
• CS – loss of 306 agents
• Barclays – no loss
• Jefferies – no loss

The other area where we think analysts could be wrong is on ARPA inflation. The street assume c. mid-teens ARPA inflation next year. We think it will be extremely hard for Zoopla to achieve this because of Agents Mutual. Many agents are currently talking to both Rightmove and Zoopla discussing large discount for them to stay on their portal. Anecdotally, we heard of 20-40% special discounts offered for agents that were about to leave Zoopla but in the end remained because Zoopla’s conditions were so favourable. In our base case scenario, we assume 10% ARPA inflation which is below the street but, arguably, still optimistic in light of a couple of data points we received so far.

In terms of margin assumptions, we assumed 60% operating leverage from incremental sales which admittedly may prove to be too harsh as the company may well cut aggressively on marketing costs. There could be some upside to our numbers there.

See below key assumptions:

And resulting key financials:

Assuming fair EV / EBITDA multiple of 18x, which is at the high end of Rightmove historical average, we see c. 30% downside. Please note that our numbers show how EBITDA in 2015 could easily be in the £30s million when current consensus is for £48m. Such steep earning revision will also bring about a multiple compression which we have not included in our base case scenario.

Catalyst