There is no doubt that home ownership has been and will continue to be a fundamental pillar of the American economy. In fact, despite some moderate moves in the right direction, current weakness in this area has done nothing to help jump start GDP back into truly expansionary territory. The arguments of the why and how of trends in housing are complex (and more suited to a separate discussion), but there are signs of thawing in what has been a tepid expansion out of the recession. Broadly, housing starts are on the rise, millennial interest in becoming homeowners is on the mend, household formation is up, and mortgage interest rates are back down to record lows. There are certainly concerns (consumer debt, labor participation), but overall, trends look favorable to me. There are deals to be had across the industry, but traditionally these fall in goods-producers (such as a favored position of mine, USG Corporation (NYSE:USG)) and not technology companies.
Zillow (NASDAQ:Z) (NASDAQ:ZG), however, is a technology that is fundamentally impacted by shifts in the housing space. The real estate business seems stuck in the old world of 3-6% commissions here in the United States despite significant change elsewhere globally when it comes to fees. Fellow Seeking Alpha Contributor Daniel Carlson hit the nail on the head recently in his own Zillow publication, and I echo his macroeconomic and secular sentiments regarding the industry. While I don't think things will change overnight, technology will force some change one way or another - it always does. As a consolidator in the space after scooping up Trulia early in 2015, there simply isn't much competition for Zillow when it comes to the online real estate market. First-mover advantage is very real in technology, and that is why the market has given Zillow a multi-billion-dollar valuation with not much to show for in profits.
When Will Zillow Make Money?
At the end of the day, it is important to remember why we invest in the first place. To me, the reason for investing is simple, and what you'll find in any economics textbook. Investors lend capital to companies that need it to invest in development and expansion. In return for those funds, we nab a portion of the business. Why own a business? A share of the profits of course - either current or future. If a business never makes profit (generates a return on capital you have lent), there is simply no reason for you to lend.
Despite an amazingly fragmented and large addressable market, Zillow has seen a steady acceleration of GAAP net income losses - not gains - over the past several years. This is despite strong revenue growth and continued adaptation by increasingly technology-savvy consumers and realtors (perhaps grudgingly).
These increases all come down to legal and acquisition/restructuring costs primarily. Investors who have paid attention to cash flows and not earnings per share would have noticed positive operational cash flow for years because of the large amount of non-cash expenses, which is why cash burn hasn't been as much of a problem as one might think looking at the company's results. Excluding these legal costs, the picture is much clearer. So yes, GAAP losses did grow to $150M in 2015 from $75M a year prior, but that can be chalked up to:
- $35.6M in restructuring costs
- $16.6M in acquisition costs
- $27.1M in legal costs associated with Move, Inc. lawsuit
Heading into the rest of 2016, restructuring costs should be minimal. The company booked none in Q1 2016, and the TTM rate is just $10M. These costs should largely be behind the company. Likewise, acquisition costs are dropping, with 2015 booking of $16.6M well below 2014 levels of $25M; expect less than $10M in total acquisition costs in 2016. This by itself is a $40M net benefit to the company's margins.
Unfortunately, investors will have to wait for 2017 to see a less cloudy GAAP results picture. Zillow has agreed to settle the Move, Inc. lawsuit for $130M after receiving some unfavorable rulings on evidence earlier in the year. GAAP loss in the $200M range should be expected this year given the likely timing of the settlement, but the company should swing to positive GAAP earnings in 2017. Luckily for investors, Zillow has plenty of cash on hand to settle the issue without going to the bond markets or issuing more equity.
Revenue is set to finally eclipse the $1B mark in 2017. With some moderate operating leverage on the SG&A front (contraction towards SG&A/revenue of 65% from 75% in 2015), the company should eke out a mild GAAP net income profit of $30M (assumes no tax expense given net operating losses), or something in the neighborhood of $0.17/share. This estimate is in line with the high side of current non-GAAP estimates by the Street (consensus $0.53/share), given the usual $110M in stock-based compensation expense ($0.62/share) that gets excluded from non-GAAP calculations. The Street is being a little more cautious on operating leverage contraction rolling into 2017 given the relative lack of execution in prior years, and I think that does present an opportunity for Zillow (and for Zillow longs) to beat on expectations and hopefully wiggle out a little bit of upside from current prices.
With all that said, there is a long way from breakeven earnings per share and justifying a multi-billion-dollar equity valuation. Concerns continue to linger on how large the actual addressable market is for Zillow, and how to reconcile a begrudgingly paying user base (realtors) with the longevity of the business model. Despite being the obvious market leader, the company continues to spend a heck of a lot of money on selling and advertising its products. Without meaningful operating leverage - which the company has not yet proven is possible or maintainable - Zillow is simply a company with a great idea that can't monetize effectively.
For more research like this on small/mid cap companies perpetually under-followed by Wall Street and under-owned by retail investors, consider following me (by clicking the "Follow" button at the top of this article next to my name) to receive notification when I publish research. Feel free to ask any questions in the Comments section below.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.