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Zillow, the leading U.S. real-estate site, said Monday it had agreed to buy rival Trulia for $3.5 billion in stock. Shares of both companies had already rallied strongly in anticipation of a deal and added to those gains on Monday. Since the start of the year, both stocks have nearly doubled and now have a combined market capitalization of nearly $10 billion.
The bull case: The combined company continues to grow apace and there's no obvious competition that can catch up. Unique visitors to Zillow-affiliated sites rose 27 percent in June from a year earlier and Trulia's gained 20 percent, according to research firm comScore. The combined audience accounted for 71 percent of visitors to the real-estate category in June, comScore said.
But at some point, investors need to ask when the combined company will start generating real profits. Zillow has invested heavily in advertising to maintain top-line growth and seen that spending cut into profitability. The company booked an operating loss of about $17 million in 2013 and consensus estimates reflect a similar loss in 2014. Zillow and Trulia declined to comment to CNBC.
Investors shouldn't overlook the potential power of major brokers whose listings appear on Trulia and Zillow. Realogy, whose brands include such giants as Century 21 and Coldwell Banker, benefits to the extent Zillow and Trulia attract buyers. But those brokers ultimately hold the keys to listings under their roofs and could take them away if the relationship sours.
A Realogy spokesman said "our existing marketing agreements with Zillow and Trulia are important to us, and they will continue with the newly combined entity."
There also may not be many more agents willing to pay for Zillow and Trulia's services. Agents tend to pay Zillow to include their listings on its site in order to get exposure to its audience. If the listings don't lead to enough transactions, it can be hard for an agent to justify the payments to Zillow.
Bradley Safalow of PAA Research pointed out that both Zillow and Trulia rank below other platforms like Realtor.com in terms of leads that create actual transactions. Fewer than 15 percent of agents nationwide can afford a product such as Zillow or Trulia that costs $300 per month, according to a PAA survey.
The direct benefits of the merger aren't very big relative to the company's market capitalization. Zillow said it expects to enjoy $100 million in annual cost savings by 2016. Those savings, while significant, probably won't grow very much in future years.
Some may argue that Zillow's valuation looks reasonable compared with other dominant property sites. London-listed Rightmove, for instance, has a market capitalization of about $3.7 billion. Given the much smaller population in the U.K., Zillow could conceivably be worth three times as much. But that argument seems risky so long as Zillow continues to spend heavily on advertising.
Shares of both Zillow and Trulia have had a remarkably smooth ride this year while many other growth stocks stumbled. Without any obvious levers left to pull, Zillow many not be so lucky the next time investors start asking tough questions.
—By CNBC's John Jannarone.