- Redfin's 180-day IPO lock-up has expired.
- Per its S-1, private equity and insiders have a cost basis under $3 and collectively own nearly 70 million shares. Redfin also has 8.75 million of vested options.
- Redfin's underlying business is real estate brokerage and revenue growth is slowing. The business isn't scaling.
On January 10, 2018, on Market Adventures, I wrote a short piece about two companies with fast approaching 180-day IPO lock-up expiration dates. The two stocks in question were Roku (ROKU), then trading at $44.73, and Redfin Corporation (NASDAQ:RDFN), then trading at $26.93 (see here). Of course, there are no free lunches in finance and the more obvious shorts, like these two stocks, tend to have high short interest and therefore the puts for both were and remain very expensive given the high implied volatility. Therefore, you can be right about the stock declining and still lose money on your put option, so you need to be precise when it comes to timing.
In today's write up, I want to discuss Redfin.
Elevator Pitch - Short Thesis
Redfin loses money and the business model isn't scaling. Revenue in its core brokerage business is decelerating, Q1 2018 guidance missed consensus estimates, the 180-day IPO lock-up is over and insiders can start selling their low cost shares, and the company's fully diluted market capitalization is $2.08 billion.
Moreover, as I noted in the January 10, 2018, piece, private equity and insiders own their stock with a cost basis under $3.
Even though I liked Redfin as a short in the mid to high $20s, in early January, we wanted to wait to purchase puts until after 180-day IPO lock-up expiration and after evaluating February 22, 2018, Q4 2017 earnings.
In terms of earnings, Q1 2018 guidance trailed analyst expectations. The conference call also contained refreshing candor that nonetheless was bearish as there's tangible evidence that revenue growth rates are decelerating. However, before we dive into the fundamentals and valuation, I want to circle back and highlight the dramatic amount of stock supply, post the 180-day lock-up.
Share count and dilution
Per Redfin's FY 2017 10-K (see here), as of February 20, 2018, Redfin has 81.8 million shares outstanding. For perspective, Redfin sold 10.6 million shares when the company went public, selling shares at $15 a piece.
On August 2, 2017, we completed our initial public offering, or IPO, in which we issued and sold 10,615,650 shares of our common stock (including 1,384,650 shares pursuant to the underwriters' option to purchase additional shares) at a public offering price of $15.00 per share. The aggregate gross proceeds were approximately $159.2 million.
So prior to the 180-day IPO lock-up, you had a float of 10.6 million shares. Per Fidelity, the 90-day average volume for Redfin was 928,000 shares.
From a supply and demand perspective, during the first 180 days, you had a tiny float of only 10.6 million shares and you had some institutional holders that got long the name. Therefore, the freely traded float was much smaller and this led to dramatic price movements in either direction. Now post the 180-day IPO lock-up, the supply side of the seesaw gets much heavier. Now private equity folks are sophisticated and will not all run for the exit right away as that would tank the stock. But insiders with small stakes have strong incentive to cash in some low-cost shares.
81.8 million shares plus 8.75 million options equals 90.55 million shares. Today's price $22.80 x 90.55 million shares equals a market capitalization of $2.08 billion.
Despite rapid revenue growth, Redfin makes no money. In other words, the business model isn't scaling, despite higher gross margins. For example, from FY 2014 to FY 2017, absolute gross margin dollars increased from $32.1 million to $111.8 million, or by $79.7 million, yet Redfin still lost money on its income statement.
More interestingly, the company only has 0.67% U.S. market share measured in aggregate value of real estate transactions. Per the Q4 2017 conference call (see here), the company competes in 86 markets, yet 69% of its revenue is derived from 10 markets.
In FY 2017, Brokerage revenue was $330.3 million out of $370 million (89% of revenue). Partner revenue (referrals) was $21.2 million, and other was $18.5 million. Other revenues are from Redfin Now, mortgage and title services. Note that the "other" segment has negative gross margins.
Negatives From the Conference Call
A) Q4 revenue growth was only 36% if you exclude Redfin Now. Redfin Now has tiny margins, too.
B) Reducing selling commissions for listing from 1.5% to 1% in select markets. Seem like desperation for revenue growth and intense competition drove this decision.
C) Redfin Now seems like a blatant attempt to drive headline revenue growth.
D) "Other" Segment Has Negative Gross Margins
F) Slowing brokerage growth
G) Management is willing spend aggressively for growth
H) By reducing selling commissions from 1.5% to 1%, in select markets, they are forced to lower buyer rebate checks, as they make more money representing buyers than being the listing broker (assuming a non Redfin buyer).
Direct Quote they make more from buyers than sellers
Redfin is a real estate brokerage firm that has masqueraded as a technology company. Yes, the company's website is excellent and they have some innovative features that streamlines the paper work and appointment process. In fact, we bought our current house and sold our condo using Redfin. The process was good as our agent was both excellent and very seasoned. So as a consumer we liked our Redfin experience. And yes, we did receive a rebate check a few weeks after the closing date (like 0.6% of the purchase price). So since consumers like this service my sense is there are a fair amount of retail investors long the stock. However, there is a big difference between liking a company as a consumer and identifying a good investment.
Moreover, it is crystal clear that over the past four years Redfin hasn't disrupted the real estate brokerage model. This isn't a business that easily scales and since this is a very important transaction for most buyers and sellers, important steps can't be eliminated for efficiency. There's a lot of red tape and hand holding that needs to occur. Like they say about politics, all real estate is local and top producing brokers that work for traditional agencies will fight back and find other ways to add value.
Redfin shares are overvalued and insiders and private equity should be inclined to cash out shares for a hefty profit. Are there enough retail investors on the other side willing absorb the 180-day post IPO lock-up volume of shares?
Our strategy is simple. In a commission-driven industry, we put the customer first. We do this by pairing our own agents with our own technology to create a service that is faster, better, and costs less. We meet customers through our listings - search website and mobile application, reducing the marketing costs that can keep fees high. We let homebuyers schedule home tours with a few taps of a mobile phone button, so it’s easy to try our service. We create an immersive online experience for every Redfin-listed home and then promote that listing to more buyers than any traditional brokerage can reach through its own website. We use machine learning to recommend better listings than any customer could find on her own. And we pay Redfin lead agents based in part on customer satisfaction, not just commission, so we’re on the customer’s side.
Our efficiency results in savings that we share with our customers. Our homebuyers saved on average approximately $2,700 per transaction in 2017. And we charge most home sellers a commission of 1% to 1.5%,compared to the 2.5% to 3% typically charged by traditional brokerages.
Redfin generates most of its revenues from the traditional brokerage segment.
Redfin Partner Program
To serve customers when our own agents can’t due to high demand or geographic limitations, we’ve developed partnerships with over 3,200 agents at other brokerages. Once we refer a customer to a partner agent, that agent, not us, represents the customer from the initial meeting through closing, at which point the agent pays us a portion of her commission as a referral fee.
In the first quarter of 2017, we began offering an experimental new service called Redfin Now, where we buy homes directly from home sellers. Customers who sell through Redfin Now will typically get less money for their home than they would listing their home with a real estate agent, but get that money faster with less risk and fuss. We believe our industry leading algorithms for calculating what a home is worth will limit the risk that the price we pay a Redfin Now customer for her home is below the price we charge a new buyer for that home.
We currently offer Redfin Now to a limited number of customers in two markets. We are evaluating the results of the Redfin Now test to determine if we should expand the service to more markets, continue at the current scale, or discontinue the experiment.
This article was written by
Courage & Conviction has been investing for over twenty years and has spent five years working as a buy-side analyst within a $45 billion investment-grade bond department, 3.5 years as an energy analyst, in addition to various other corporate finance roles. He has been a full time investor and author since 2020.
He leads the investing group Second Wind Capital, providing in-depth analysis on under-the-radar smallcap value ideas. He shares his real-money portfolio and does research based on fundamentals, synthesizing industry ecosystems and regularly interviewing management teams. He teaches community members to embrace volatility and exercise patience to drive alpha creation.
Analyst’s Disclosure: I/we have no positions in any stocks mentioned, but may initiate a short position in RDFN over 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.
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