Army of Shorts Rejoice After the 23% Drop

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

Some companies in the market have massive short interest relative to their outstanding float.  Companies like Research in Motion have short interest that is about 20% of the current float, but few compare to the short interest of Zillow (NASDAQ: Z).  Zillow is a web based marketplace for buyers and sellers of real estate.  Out of 17 million shares in the float, about 7.2 million are short.  This is about 42%.  Insiders have been selling stock too (not short of course).  They sold 525,000 shares in September.  Shorts have had a decent record since September due the stock dropping from above $45 to $34 on Monday’s close.  They had a nice payoff after the earnings were released after market on Monday when the stock dropped 23% to $26.69.

Many shorts have been saying for a while that Zillow isn’t expanding exponentially like other web based companies, like Facebook (NASDAQ: FB).  Unlike Facebook, where people buy ads on their own online, Zillow customers usually buy after being convinced by sales staff.  This makes the company harder to scale up without hiring a ton of salespeople like Groupon (NASDAQ: GRPN).  Facebook turns about 30% of its revenue into operating income whereas Zillow only turns about 5% of its revenue into operating income.  This is an inefficient business and it is due to the mass of sales stuff not needed in a scalable Facebook-like company.  At least with Groupon there is a massive customer base on both sides of their marketplace.  Both the customer and the business owner benefit from the coupons on Groupon and there are a lot of customers and businesses.  With Zillow, one side of the marketplace is quite limited.  There are only so many real estate agents to pay the subscription fees.  Only recently has Groupon's sales and admin cost stopped growing with sales.  Meanwhile, Wall St has sent Groupon's stock price plummeting.  It's down 85% in the past year.  Is this really the path you want to follow?

The Q4 guidance by Zillow after market on Monday displayed the lack of growth compared to expected growth.  Earnings met estimates at $0.07 per share, but revenue guidance for Q4 was $30-31 million (lower than Q3 actual revenue) when Wall St. was expecting $32.5 million.  Although the guidance isn’t that much lower, a company trading at such an insane valuation needs to be meeting and beating expectations.

What happens from here?  The valuation after the 23% drop is still crazy.  Based on the earnings Q3, the PE is about 109. Growth for Q3 revenue was up 67% from last year but sales costs are coming up with it.  If we assume that they have been picking the low hanging fruit, margins could get even worse in the future.  Zillow is trying to grow through a few recent acquisitions that could be more scalable.  They bought Buyfolio earlier this year and announced Monday that they will buy a mortgage software company called Mortech for $12 million.  However, these companies are tiny compared to the $1 billion valuation of Zillow.  Will these acquisitions make a difference?  So far the market is going with the shorts and favors drilling down the massive valuation. 

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mthiessen has no positions in the stocks mentioned above. The Motley Fool owns shares of Facebook and Zillow and has the following options: long JAN 2014 $20.00 calls on Facebook. Motley Fool newsletter services recommend Facebook and 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.If you have questions about this post or the Fool’s blog network, click here for information.

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