Two Stocks, One Overvalued Industry Worthy of a Short

Brian is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Shares of online real estate companies Trulia (NYSE: TRLA) and Zillow (NASDAQ: Z) traded considerably higher last week following strong earnings and a fury of short covering. Both companies saw explosive growth, which can not be denied, yet because of their valuations there is little value left in either these two stocks. While one company might become a good investment once its price is more attractive, the other looks to be a prime short candidate; but which one?

Both Trading Higher

Over the past week, shares of Trulia have increased by 42% and Zillow by 25%. It all started on Tuesday when Trulia reported earnings that missed on the bottom line and barely beat on the top line. The company’s guidance was better than expected and mobile/monthly visitors showed strong gains across the board. As a result, the market saw this mixed report as a positive and its stock traded considerably higher. Zillow, on the other hand, beat both top and bottom line expectations by large margins, increased guidance, and showed better growth/user interaction across the board.

Both Zillow and Trulia’s gains were less related to earnings and more related to short interest. Trulia has 18.2% of its float short as of Jan. 31 and Zillow had 41.1%. Therefore, I find it somewhat odd that Trulia traded higher on a weaker earnings report with less short interest. It seems logical that Zillow would have been the stock to rise more than 40%, and Trulia by 25%. With that being said, both stocks are overvalued, and although I think Zillow is the far better company, both are way too expensive.

Valuation

Both companies are seeing near equal growth, between 70% and 75% year-over-year. Zillow is the larger company, with revenue of more than $100 million compared to Trulia’s $70 million. Therefore, the fact that Trulia and Zillow have equal growth is also a reason for concern, regarding Trulia, as a smaller company should post better year-over-year returns under the same business model.

Zillow is also a profitable company, with net income of $6 million and operating cash flow of more than $30 million over the last 12 months. Trulia has posted a net loss of almost $6 million and has operating cash flow of just $3.77 million over the last year. Therefore, Zillow with its profit margin of 5%, is a much better and more efficient company that Trulia with its profit margin of (16%).

Good Short

If you feel confident in an investment in this space, then there is no doubt that Zillow is by far the better company. The stock’s short ratio, and that of Trulia, was due to a number of bearish articles, most notably by Citron Research, that question the valuation on the space. Now, with strong earnings, there are a lot of investors who are more optimistic, and are willing to place large valuations on these two companies. However, you must not forget the valuation-related concerns that had disallowed the stocks from trading with momentum over the last several months.

Zillow, is trading with a price/sales of 12.09 and a forward P/E ratio of 54.79; Trulia also trades with a price/sales over 12 and is not profitable, nor is it close. In some ways I can understand the market’s valuation for Zillow. It’s an efficient business and is fast-growing. And although I wouldn’t buy at these levels, I must acknowledge the fact that it trades with a price/sales that is much less than Facebook yet is growing twice as fast. The reason this is relevant is that the market awards higher price/sales and P/E multiples to stocks that are fundamentally growing fast. Once growth slows, and expectations aren’t being met, these ratios are typically supposed to decline.

I view Zillow as overvalued, but not too expensive. Trulia on the other hand is along for the ride, and is trading higher because it is growing yet remains an unprofitable company that lacks efficiency. In my opinion, a price/sales of 12.24 is way too expensive for this stock, and as a result I view it as a prime short candidate.

Conclusion

The important thing to remember about these social media stocks and the high valuations that they sport is that there is limited revenue in one segment. Zillow and Trulia can only grow with real estate; neither will ever become Priceline or Google with hotel and search businesses. These are two companies that still have revenue upside, but it is unknown as to whether or not agents will continue to utilize these sites once the real estate market recovers.

Far too often we connect companies and compare stocks that are fundamentally different; such is the case with Trulia and Zillow. Trulia is way too expensive compared to fundamentals and Zillow might be worthy of its valuation due to efficiency and the gold standard that values a company in the social media space. Either way, I warn investors of chasing the quick gains with either company, and suggest that investors wait before buying Zillow and prepare to short the overpriced Trulia. 


BrianNichols has no position in any stocks mentioned. The Motley Fool recommends Zillow. The Motley Fool owns shares of Zillow. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

blog comments powered by Disqus