Quick Pitch: Matterport (MTTR)

Merger Arbitrage: 25% Upside

This is a merger arbitrage opportunity with a 25% spread and an expected closing during 2024. I am quite puzzled by such a wide spread and it feels like I might be missing an important risk. Any feedback on my research is welcome.

Matterport is a $1.4bn market cap company, which provides 3D capture software and hardware that allows users to create digital twins of physical real estate spaces – i.e. 3D models for apartments/houses in sales listings. The majority of the company’s revenue comes from subscriptions to its cloud platform, where images and spatial data of a physical space are converted into an interactive 3D model.

In late April, the company agreed to be acquired by CoStar Group (CSGP), a $34bn publicly listed real estate information and analytics provider which also operates several commercial and residential real estate listing sites, such as LoopNet, Apartments.com, and Homes.com. Merger consideration stands at $2.75/share in cash and $2.75/share in CSGP stock, or $5.5/share in total. That’s a 25% spread from the current prices. MTTR’s shareholder approval seems likely given that the offer comes at a gargantuan 200%+ premium to the pre-announcement levels and that 15% of shareholders are already in support of the merger. CSGP appears to be a very motivated buyer and I think the risk of the buyer walking away from the deal is minimal. The companies expect the transaction to close by the end of the year.

Aside from the steep potential downside to the pre-announcement levels, I believe the spread could be partially explained by a combination of:

• Somewhat more complicated structure of the merger consideration. The stock portion is subject to a collar. Any decline in CSGP stock below $77.42/share would result in a lower than $5.5/share merger consideration. However, CSGP shares would need to decline by more than 40% for this arb to start losing money. Also the stock portion of merger consideration could be easily hedged by shorting CSGP or buying put options (albeit option liquidity is quite low).
• Uncertainty surrounding antitrust approval, given that MTTR is the dominant player in the 3D imaging space, and that CSGP has already been under antitrust scrutiny over recent years.

• The risk that MTTR might lose and be required to pay substantial damages in several lawsuits. However, the merger agreement was specially made unconditional to the outcome of these lawsuits and MTTR’s management has explicitly stated that even negative outcome will not impact the consideration payable to MTTR’s equity holders.

I will review these points in more depth below.

 

Rationale for the merger

CSGP has historically been focused on commercial real estate information and analytics. Over the last decade the company has also expanded into the real estate online marketplace business with a number of acquisitions, most notably LoopNet (2012, focused on commercial real estate listings) and Apartments.com (2014, residential rental listings). Since the acquisitions, CSGP has transformed both of these marketplaces into industry leaders.

From the Q4’20 conference call:

In the 3 years prior to CoStar Group acquiring LoopNet, revenues on average were negative 2.3% a year. In the past 2 years, LoopNet has grown almost 20% a year. And already, we have grown LoopNet’s revenue more than fourfold since acquisition. In the 3 years prior to acquiring Apartments.com, revenue grew at 7.7% a year on average. In the past 3 years, Apartments.com has grown almost 30% a year on average. Already, we have grown Apartments.com revenue by more than 6.5x.

From the Q1’24 conference call:

Three weeks ago on April 1, we celebrated the 10-year anniversary of CoStar’s acquisition of Apartments.com and what an amazing 10 years it’s been. We transformed the way consumers find their next rental home, growing our revenue from $75 million in 2014 to over $1 billion today. Our sales team is 5x larger, delivering 3,225% more sales than when we started. We went from fourth or fifth place in that industry in terms of traffic to the #1 traffic position with the brand most recognized by consumers.

More recently, CSGP has been pursuing a similar playbook with Homes.com, a residential for-sale listing-focused online marketplace acquired in 2021. Since the acquisition, Homes.com has been growing rapidly driven by investments primarily in marketing, allowing the business to overtake a number of competitors and establish itself as the #2 player behind Zillow. Management expects to increase investments in Homes.com further this year with c. $1bn to be invested in the residential marketplace business vs c. $0.5bn in 2023.

From a media article published in Nov’23:

“We’ve done this before, When we acquired LoopNet, we increased traffic 400%. When we acquired Land.com, we dramatically increased their traffic. When we bought Apartments.com, it was behind ForRent, it was behind Apartment Finder, it was behind Apartment Guide. It was behind Rent.com. It was behind Zillow and it was behind Craigslist. And over the course of two years, we worked on providing high-quality content and a better UX. We focused on SEO, SEM brand building, and we grew the Apartments.com traffic fivefold, then tenfold, and became the No. 1 player.”

The pending acquisition of MTTR fits the picture and will allow CSGP to boost its for-sale residential real estate marketplace business. MTTR is the dominant player in the 3D imaging space. Virtual tours created using MTTR’s hardware and software are published with the listings on the largest online real estate marketplaces in the US, including Zillow and Homes.com. The presence of virtual tours on listings correlates positively with view count and duration. CSGP intends to make MTTR’s 3D virtual tours exclusive to Homes.com. See quotes from CSGP’s conference call below.

We intend to add Matterport as one of the benefits of Homes.com membership. We believe adding 3D digital twins for Homes.com members will increase the leads we deliver, increase customer satisfaction, increase renewal rates, increase sales and increase site traffic further. We have thoroughly researched the many 3D digital twin solutions out there and have concluded that Matterport is the best solution for our clients’ needs.

[…]

In March this year, there were over 7.4 million views of Matterport 3D tours on Apartments.com. Visitors who interact with the Matterport on Apartments.com spend 16.6 minutes on the site, which is 134% more than the 7.1 minutes time on site if they do not interact with a Matterport. Properties with a Matterport generated 74 leads, which is 10x the 7 leads generated for a property without Matterport.

The point I’m trying to make here is that the acquisition of MTTR aligns very well with CSGP’s key strategy of growing Homes.com business and, for this reason, the likelihood of the buyer walking away should be minimal.

 

Merger consideration and hedging

Merger consideration is comprised of $2.75/share in cash and $2.75/share in CSGP stock. The stock portion is subject to a symmetrical collar based on CSGP’s 20-day VWAP three days before the transaction closing. Here’s how the stock exchange ratio will be calculated at different CSGP prices:

• Exchange ratio will be equal to $2.75 divided by the weighted average CSGP share price if CSGP stock price is between $77.42 and $94.62 per share (vs $78.2/share currently).
• 0.02906 CSGP shares if the average stock price is above $94.62.
• 0.03552 CSGP shares if the average stock price is below $77.42.

In terms of dollar value, the stock portion of merger consideration could fall below $2.75/share if CSGP shares trade below $77.42. CSGP is currently trading just above this level at $78, so there is a defintelly a risk that the total merger consideration will end up below the $5.5/share headline figure in dollar terms. However, CSGP stock would need to drop to $45/share (or down 40%+) for this arb to start losing money. Downward move in CSGP price can be easily hedgeable. There is also an added complexity due to timing difference – the 20-day weighted average CSGP price for exchange ratio determination will not necessarily match CSGP price at the time when the merger consideration is received. But this could also be addressed by adjusting the hedges after the exchange ratio becomes more clear.

There are several hedging options:

• Shorting CSGP (at a 0.03552x ratio) – this would fully protect from any downward moves in CSGP price but would leave arbitrageurs exposed CSGP shares spike upward. The return on this arb would decline to 14% at a $100 CSGP share price. Plenty of cheap CSGP borrow is available (at 0.3% annual fee).
• Buying CSGP $80 Jan’25 put options (currently at $7) – the premium paid for the option cuts into profits from this arb, but protects from negative CSGP price moves.
• Buying CSGP $75 Jan’25 put options (currently at $5.16) – same as above, just at the lower option exercise price and cost.

Calculations of returns for these hedging strategies at various CSGP prices are indicated in the table below.

Note that CSGP options are relatively illiquid and have wide bid/ask spreads. Other expiration dates (the merger might not close by Jan 2025) and exercise prices would deliver similar arbitrage returns, e.g. July 2025 options are c. 30% more expensive, so the upside would be cut by only an additional 1.5%.

 

Regulatory approval risk

CSGP has been under antitrust regulator scrutiny on several instances over the last few years:

• Back in 2020, CSGP’s acquisition of rental listing marketplace operator RentPath was called off after the FTC sued to block the transaction due to concerns of reduced competition in the online rental marketplace. The regulator highlighted that the combined company would have held dominant market share in certain sub-markets (e.g., a 70% share in the US apartment complexes with 200 or more units).
• Earlier this year, the FTC filed a brief regarding the ongoing legal proceedings between CSGP and another real estate online marketplace, CREXi. This came after CREXi had countersued CoStar for unfair and monopolistic behavior. The lower court eventually dismissed these claims, however, FTC pushed the court to investigate CREXi’s allegations.

Given this antitrust scrutiny, the market might be worried that FTC might challenge the pending transaction (I am just trying to guess reasons for the wide arb spread). The current merger is significantly larger than the previously-attempted CSGP-RentPath combination ($0.6bn vs. $1.6bn EV), but at the same time RentPath held a smaller market share in its market (16% according to this report) than MTTR does for 3D virtual tour rendering.  However, FTC’s decision to sue CSGP’s acquisition of RentPath was based on horizontal competition concerns (i.e., RentPath and CSGP were two direct competitors with significant market shares), whereas CSGP/MTTR would be a vertical integration with CSGP being MTTR’s customer rather than a competitor. Vertical integrations are far harder for regulators to challenge.

As for the FTC’s brief in the CSGP-CREXi proceedings – the key aspect of that legal case revolved around antitrust issues in the commercial real estate sub-segment. Meanwhile, MTTR appears to be focused largely on residential real estate marketplaces, with less significant presence on the commercial side (see the quote below). Matterport highlighted that approximately 50% of its subscription revenues come from the residential real estate end-market. A large portion of the remaining subscription revenues are generated from non-real estate customers, suggesting that the revenue share attributable to the commercial real estate market is likely to be insignificant. From the Q4’23 conference call:

We’re most known for creating digital twins and virtual tours of residential real estate, so homes, apartments and the like. But we’ve also expanded to essentially be able to create a digital twin of any building. So commercial properties, apartment buildings, office high-rises, hotels, even in the industrial category, manufacturing facilities, factories and the like.

With my limited knowledge of regulatory concerns/approvals in similar instances, I find it hard to believe regulators would move to block this one, especially when MTTR is not the only game in town for virtual tour creation.

 

Matterport existing litigations

I took a deeper look into Matterport’s lawsuits after noticing that during merger negotiations CSGP initially wanted safeguards against potential litigation losses. The buyer offered to reduced cash consideration by the exposure from pending lawsuits and instead issue CVR, which would be contingent on successful litigation outcomes (see this S-4 filing). However, MTTR’s management quickly stated that no portion of the merger consideration should be contingent, and, in turn, CSGP promptly agreed to remove the CVR and leave the cash+stock consideration unchanged. This seems to display the acquirer’s view that any litigation losses are unlikely to be material.

Section 6.16          Certain Litigation. The Company shall promptly advise Parent of any Action commenced after the date hereof against the Company and/or any of its directors (in their capacity as such) by any Company stockholders (on their own behalf or on behalf of the Company) relating to this Agreement or the transactions contemplated hereby, and shall keep Parent reasonably informed regarding any such Action. The Company shall give Parent the opportunity to consult with the Company regarding, or participate in, the defense or settlement of any such Action, and shall give reasonable and good faith consideration to Parent’s advice with respect to such Action. The Company may not enter into any settlement agreement in respect of such Action against the Company and/or its directors or officers relating to this Agreement or any of the other transactions contemplated hereby without Parent’s prior written consent. In the event of, and to the extent of, any conflict or overlap between the provisions of this Section 6.16 and Section 6.3, this Section 6.16 will control.

Below is a list of lawsuits that Matterport is currently involved in:

• In Jul’21, MTTR was sued by former employee and stockholder William Brown, who claimed that invalid lock-up restrictions were imposed on his MTTR stock, preventing him from trading his shares. After an expedited trial in Dec’21, the court ruled in Jan’22 that the transfer restrictions did not apply. Subsequently, Matterport appealed, but the court upheld the ruling. The equity holder then filed an amended complaint in late 2022, claiming that MTTR did not register his requested share transfer on time. And finally, just last week (i.e. after the merger agreement was signed), the Delaware Court of Chancery issued a ruling in favor of the plaintiff, awarding the equity holder $79m plus interest in damages “as a result of his inability to trade his shares before the January 2022 post-trial opinion.” MTTR stated that it intends to appeal the ruling and unambiguously stated that the recent court award “does not impact the consideration expected to be paid to Matterport stockholders.”
• In Feb’24, MTTR was sued by two stockholders, claiming that management breached its fiduciary duties by issuing $225m worth of earn-out shares as part of the SPAC transaction in 2021. The plaintiffs have requested an award of damages as well as the replacement of the company’s management. This lawsuit is still in very early stages, and the outcome is not expected before closing of the merger.

• In May’20, one of MTTR’s customers, Redfin, was sued by residential real estate brokerage Surefield, which claimed that Redfin’s use of MTTR’s 3D-Walkthrough technology infringed on several of Surefield’s patents. MTTR had agreed to indemnify Redfin (i.e., compensate for potential losses) in the litigation. After a trial in May’22, the jury found that Redfin had not infringed upon any of the claims, and a final judgment was entered in Aug’22. Surefield has since filed post-trial motions, seeking to reverse the verdict, while MTTR, in turn, filed a declaratory judgment against Surefield. The litigation is still ongoing, but looks to be moving in a favourable direction for Matterport.

 

Matterport

MTTR went public via a SPAC in mid-2021. The company generates 60% of its revenue from subscriptions, with the rest coming from the sales of services and products, such as 3D cameras and motorized mounts for smartphones. MTTR has grown rapidly over recent years, displaying 16%-29% annual revenue growth during 2021-2023, while gross margins have generally stood above 40%. The company has so far been unprofitable and cash-burning, but management expects to reach breakeven at some point in late 2024 or 2025.