Zillow Group, Inc. (NASDAQ:Z) (NASDAQ:ZG) is a classic tech growth company financially with great revenue growth that is only matched by their spending and legal fees. They have recently provided their 2016 results and 2017 guidance, and I want to refresh my analysis from six months ago, which I provided here. While I recommend reading the whole thing for a more detailed dive into their revenue generation sections, the conclusion was that they were priced fair to high, and would need to be a long-term growth play to be worth a position in your portfolio.
Zillow has made several business model updates since my last article. The first is to add a "self-serve auction-based pricing platform for the Premier Agent Advertisers" as described by the CEO Spencer Rascoff. This basically allows agents to bid for pieces of a zip code. More investment means a bigger slice of the leads.... until your competitors match your bid or exceed it. Mr. Rascoff gives a great example of how this plays out on their earnings call (found here):
They're essentially bidding for a share of the impression. So, if Kathleen and I are the only two agents in a ZIP and we each want to pay $100 in that ZIP code, we're going to each get half of the impressions, and now along comes RJ, and he puts $100 into the pool, and he gets a third of the impressions, and I get a third, and Kathleen gets a third.
And, now Kathleen says, hey, my ROI here is great. I want to up my spend from $100 to $200. Well, now she gets two-fourths of the impressions and RJ and I were just diluted. And now I come along and put $10,000 into that ZIP code and now I'm getting 90%-odd of the impressions in that ZIP and everybody's CPM just went up and my share went way up and Kathleen's and RJ's just got diluted. And now my ROI is too low and I pull my spend back, everybody gets undiluted, et cetera, et cetera. So that's how it works.
I am thrilled by this pricing model as it allows the market to set prices and removes Zillow from the risks of under/over pricing zip codes. There is risk in that a market downturn could cause pricing to plummet, but this risk exists regardless since Zillow would need to price incentives in during market downturns to minimize volume loss. Zillow does provide estimated ROI to agents by zip code as well to help them balance their spend as part of their agent interface software.
Zillow also has a new "emerging" marketplace titled New Construction. This allows home builders to advertise their available lots and styles to the public. Similar to the real estate agent interfaces, Zillow also provides these companies with a detailed interface full of market information for the builders. They estimate this as a $1B total market.
Zillow ended 2016 with revenue growth of 31% at $847M. This follows a year where they nearly doubled revenue, so it is slower, but that was heavily based on acquisitions.
Earnings came in at -$220M (-$1.22/share). Two items worth noting are a $130M litigation charge (labor pay dispute settlement) and a share-based compensation of $106M. Zillow is fond of using a non-GAAP adjusted EBITDA, which excludes share-based compensation. I generally disagree with this principle, as it is a cost to the shareholders to dilute them by an incremental 1.58% that would be paid to employees in cash if not in equity, but I share it for reference. It is worth noting though that the share-based compensation was steady YoY instead of growing as it had significantly in previous years.
In terms of earnings growth, GAAP loss slowed its rate of growth at -40% YoY. Loss/share had nearly tripled for the previous 3 years based on costs of acquisitions, expenses, and legal fees. While legal fees are typically one-time expenses that is reasonable to exclude, it is worth mentioning that Zillow has had significant legal expenses repeatedly due to concerns over personnel and business acquisitions, technology ownership, and patent infringement. There are three pages in their 10-k for 2016 devoted to details of their cases in the last few years, the most that I have ever seen (here). This seems to be a theme that may continue to drive losses as there is another open case with VHT that started trial in January.
Adjusted EBITDA fell due to the legal costs at $14M, an 84% drop YoY. If you exclude the legal settlement (+130M), it is 65% growth.
Costs increased by 20% YoY, heavy on marketing and technology spend. This is in line with their strategy and less than the increase in revenue, showing mild restraint and operating margin improvement.
To summarize 2016, revenue grew 31%, but ultimately led to -40% EPS based on legal issues and increased spending. Even including Zillow management's adjustments, EBITDA growth slowed showing a maturation of the business model. This places an irrelevant P/E or PEG and 7.4x P/S.
Zillow outlined four key strategies for 2017:
- Grow audience and engagement
- Grow Premier Agent revenue
- Grow "emerging" marketplaces
- Maintain culture and retain talent
Audience and engagement centers on driving user growth and engagement. User growth is primarily driven by marketing as well as reputation. The emerging marketplaces (i.e. NYC rental, new construction, etc.) also aid user growth, as it brings people to the Zillow family websites. Engagement centers on continued investment and development of the consumer interface.
Premier Agent revenue growth centers on the rollout of the auction style lead management, revenue from the agent software services, and continued growth via share of total commissions (currently at ~5%). As they take share in this area, they should expect the auction-based pricing to drive ad dollars accordingly.
Growing emerging marketplaces centers on the "other" categories at Zillow such as mortgage services, NYC focused sites, New Construction, etc. These experience disproportional growth based on their relatively small sizes individually and are expected to mature segments themselves. This seems to be a major expense area for research, development, and acquisition costs, but the growth rates partially justify it.
Zillow's guidance for 2017 revenue was $1.03-1.05B. This was slightly below Wall Street estimates and represents a revenue growth of about 24%, a continued decline in the rate of growth percentage and almost exactly the same dollar value as 2016.
Earnings guidance (adjusted) was for a 19% margin versus 17%, excluding the $130M charge in 2016. This would come from operating margin improvement and is still easily wiped out by the time it is translated to GAAP earnings. Their long-term goal is 40% EBITDA margin, but they don't appear to be in a hurry to get there. Several analysts leaned on the minimal margin, but Mr. Rascoff stood by a long-term focus and repeatedly rebuffed them for implying they should be working on margin sooner. To quote (source):
Couple of years ago, when we started building out our mortgages business, we had a lot of shareholders say you should be expanding margin today and basically selling off your mortgages vertical like most of your competitors do, why are you growing head count and building out a mortgages business and again that was the right decision that we made a couple of years ago. It hurt near-term profitability, but today we have a terrific, large, growing and highly profitable mortgages business as a result.
From a risk perspective, Zillow is still tied to the real estate market. A crash in real estate (not unimaginable given rising interest rates) would lead to revenue risk as agents curtail spending during the downturn. Given their lack of profitability, this would risk needing to raise more capital and diluting shareholders.
Zillow also still has competition from the likes of Realtor.com, which boasts a broader selection. This prevents them from significantly reducing their marketing spend lest they start to lose share.
Finally, they do have further litigation hanging over their heads as they are currently in court for copyright infringement with VHT.
Zillow's results and outlook disappointed most investors. Declining revenue growth rates, increasing losses, and continuing issues with litigation are hard to stomach and help explain the recent drop in share price. On the other hand, growth is still over 20% YoY, management has shown foresight in growing the business and investing in the right areas, and they are a market leader with only 5% of share leaving plenty of room to grow. In the end, I am still aligned (if a little more reservedly so) with my previous position on their value. The share price is valued at a premium for growth, so investors buying in now should expect at minimum a 3-5 year horizon before returns are meaningful. This provides a lot of time for the many risks to Zillow's business (real estate market crash, competitive activity, etc.) to come to fruition. This would be a good add for a speculative long position based on future potential if they continue to lead the market and can turn the corner on their expenses. For core portfolios looking for growth, look elsewhere.
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.
Additional disclosure: As always, the views in this article are my own and should not be construed as investment advice. Investors should always do their own due diligence.