Markets

How Zillow May Buck the Money-Losing IPO Trend and Make a Profit

By Jim Edwards

Updated on: July 21, 2011 / 2:27 PM EDT / MoneyWatch

There is something depressingly familiar about Zillow's (Z) IPO, which went from $20 at launch to close at $35.77 yesterday, earning the company $69 million: It's yet another dot-com that is unprofitable because it relies almost entirely on advertising revenues. It even has the requisite silly name that is the hallmark of non-functional tech startups seeking equity cash.

The difference between Zillow and Pandora (P), FriendFinder Networks (FFN), LinkedIn (LNKD), Groupon (GRPN) and Demand Media is that the trend lines at Zillow suggest that the real estate porn information company could eventually become a profitable business based entirely on advertising.

Zillow makes money two ways, by selling subscriptions to real estate agents and mortgage vendors and by selling display advertising to anyone who wants to buy ads on the site. The "subscriptions" aren't really subscriptions, however. The real estate agent sub "allows local real estate agents to establish a persistent online and mobile presence on Zillow in the zip codes they serve," and the mortgage sub allows "mortgage lenders [to] make a prepayment to gain access to consumers interested in connecting with mortgage professionals." Advertising, in other words.

The trouble with advertising
Zillow's historic problem is that it has always cost more to sell those ads and run the site than it makes in fees from its clients. In Q1 2011, the company made $11.2 million in revenues but showed a net loss of $826,000. The full year of 2010 was Zillow's big breakout, it made $30 million, almost double the year before. But it still lost $6.7 million because its staffing, web site and marketing costs have always outstripped the amount it can charge advertisers. (Note how small the sums are that it generates after five years in business, by the way.)

If you express its recent results as the percentage difference between its costs and revenues, some good news emerges:

Where once Zillow's costs exceeded its revenues by more than 400 percent, now they're they're nearly the same. (These numbers are rough -- to generate them I had to mix recent quarterly numbers with full-year numbers. They're still relevant because they're expressed in percentages, not whole dollars.)

Can Zillow beat the trend?
The question couldn't be simpler, and it's the dilemma that faces every business on the planet: Can Zillow ever get those costs to go lower than its revenues, or raise prices for advertisers high enough to cover its spiraling costs?

The trend line is down. The only doubt is whether the trend will plateau at 100 percent -- which isn't good enough because operating costs don't count taxes, interest payments and all the other stuff Zillow must pay for after it has paid its regular business bills -- or continue to fall below 100 percent of its revenues.

There is some reason to believe Zillow has some pricing power with its real estate subscribers. On page 40 of its IPO prospectus the company says:

Pricing for our Premier Agent subscriptions varies by zip code.

Zillow doesn't elaborate, but I suspect that agents in busy, wealthy neighborhoods get charged more than those in quiet, rural backwaters. One presumes Zillow has an interesting formula for calculating how much it can charge per zip code. Between 2010 and 2011, subscriptions have overtaken display ad revenue as the larger portion of Zillow's ad sales.

If the real estate sector ever turns around, Zillow may find more zip codes becoming hot, high-price subscription areas. In which case, subscription revenue may take care of Zillow's problems and deliver actual earnings for its shareholders.

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Image by Flickr user Images of Money, CC.