Zillow: High Risk, High Reward

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About: Zillow Group, Inc. (Z)
by: Richard Durant
Summary

Zillow’s move into iBuying is a high risk, high reward strategy, which greatly increases their total addressable market.

The only genuine competitor in the market at this stage is Opendoor, but strong competition will make profitability difficult.

Zillow’s success in iBuying will be dependent on their ability to leverage data and manage operations efficiently.

Zillow's (Z) move into iBuying has resulted in tremendous revenue growth and, if they can become profitable, will greatly increase the value of the company. Although iBuying is likely to be a low margin and volatile business, I believe Zillow's experience estimating property prices, control over leads through their website and large financial resources give them an advantage in the market, which will allow them to be successful.

Zillow was founded in 2006 as an online real estate database company that generated revenue by selling advertising on its website. Zillow has recently shifted strategy and now operates three segments:

  • Homes: Generates revenue through buying and selling homes (iBuying through Zillow Offers). In the next 3-5 years, Zillow plans to purchase 5,000 homes per month, generating approximately $20 billion revenue annually.
  • Mortgages: Generates revenue by originating home loans. In the next 3-5 years, Zillow plans to originate over 3,000 loans per month with a 33% attach rate to Zillow Offers.
  • Internet, Media and Technology (IMT): Generates revenue through advertising as well as offering a suite of marketing and business technology products and services to help real estate agents and brokers. Zillow is aiming to expand IMT revenue to $2 billion annually in the next 3-5 years primarily by more effectively monetizing leads by prioritizing quality over quantity.

Due to the rapid growth in the Homes segment, it will soon dwarf the other segments and will make or break Zillow as a company.

Instant Buying

In a well-functioning market, buyers and sellers should be able to execute transactions quickly, at a fair price and with reasonable fees. This becomes difficult when the product is highly differentiated, has a high value, and transactions are relatively infrequent, like in real estate. As a result, home buyers and sellers are faced with an illiquid market with high transaction fees. Instant buying or iBuying is a relatively new business model which seeks to reduce friction in the real estate market and create liquidity by buying homes from sellers instantly and then selling to buyers at a later date, similar to corporate bonds where institutions such as investment banks act as intermediaries, holding their own inventory, providing liquidity for a fee. iBuyers are seeking compensation for removing friction from transactions and bearing price risk for sellers, a risk that it has a much greater understanding of through data analytics.

Innovation in the real estate market has been slow, likely due to a lack of incentive for incumbents. For individual buyers and sellers, transactions are infrequent, giving little incentive to push for a simpler solution. Real estate transactions are also large, making buyers and sellers risk averse and unwilling to try new services. There is also a significant amount of regulation and paperwork associated with real estate transactions and assistance to buyers and sellers can be valuable. These factors have led to consumers accepting the status quo even if the services provided by agents are expensive.

Figure 1: Residential Real Estate Commissions

(Source: The Economist)

Previous tech approaches to the real estate market, like Zillow and Redfin (RDFN) were unable capture a large portion of the industry's value as they worked within the confines of the existing system. iBuying is a disruptive innovation which has the potential to reshape the industry value chain and capture a huge amount of value. It is a business model which seeks to create value though, not just capture value, and its rapid rise indicates that there is latent demand for liquidity from an underserved market segment.

Some of the key features of the iBuying value proposition to consumers are:

  • Improved liquidity (sales can close as quickly as 7 days)
  • Greater certainty (no appraisal contingency or concerns over buyer's ability to close)
  • Greater flexibility (consumers are able to choose closing and move-out dates)
  • Convenience (no renovations, no showings, no agents, no negotiating)

The real estate market presents a large opportunity for disruptive innovation as it is large and relatively inefficient. It is estimated that the iBuying total addressable market in the U.S. is approximately 900 billion USD, but it is likely to be a competitive and low margin business. In 2018, iBuyers accounted for over 25,000 transactions nationally (approximately 0.2% market share) although iBuyers have currently only entered a handful of markets and are growing rapidly.

iBuyers have entered big cities with large "cookie-cutter" housing stocks first which provides them with a large addressable market and housing which is relatively easy to value and sell quickly. Although most benefits of scale will accrue in individual markets (e.g. large scale in a city will allow favorable terms with contractors like security or renovators), there will also be significant benefit to scaling across regions as it will diversify risk and should allow more favorable financing terms. New markets are also likely to be less favorable and present challenges like seasonality, heterogeneous housing stock and crime.

Despite its large potential, iBuying is a risky business model, and at this stage, it is not clear if it will be profitable or able to withstand a real estate market downturn. There is a large amount of concern amongst investors that, in the event of a real estate market downturn, iBuyers will be stuck with a large inventory of housing that it is unable to sell and is declining in value. iBuyers believe this risk is overstated as they can charge greater fees during periods of volatility. I believe iBuying is only likely to be viable if competition is low as competition will be based primarily on price, leading to low margins, and these margins are unlikely to be sufficient to compensate a company during a downturn.

Zillow

Many online businesses have achieved success by controlling the customer relationship and integrating it with however it is their industry generates revenue. For example, Netflix (NASDAQ:NFLX) controls the customer relationship and is now integrating content creation. Zillow controls the customer relationship in the real estate industry through its dominant position in lead generation and by integrating this with the actual transaction process could potentially capture the majority of the value in the real estate industry.

Zillow entered iBuying in April 2018, and although it is a relatively late entrant to the market, it is growing rapidly; aided by Zillow's brand name, financial resources and dominant position in lead generation. This is resulting in a rapid shift in the financial performance of the business as they shift from a high-margin, asset-light business to a low-margin, capital-intensive business. Revenue is expanding rapidly, and Zillow's target of $20 billion revenue annually in the next 3-5 years does not appear unrealistic.

Figure 2: Zillow Revenue

(source: Created by author using data from Zillow)

Zillow is also expanding their portfolio of offerings to cover more aspects of buying, selling, renting and financing, which gives it great potential for economies of scope, although this is not apparent from financial performance so far. Since starting the homes segment, the IMT and Mortgages segments appear to be maintaining trend growth. Zillow will likely be hoping to see strong growth in these segments, particularly mortgages, as the Homes segment continues to expand.

Zillow has the opportunity to greatly expand IMT revenue through its dominance in lead generation. Zillow's statistics show that 45% of people who request an offer through Zillow Offers end up listing their home, but Zillow is unable to manage the volume of leads generated. Zillow can potentially sell these leads to agents or receive an industry standard referral fee of approximately 1% if the home sells. To give an idea of the size of the opportunity, Zillow estimates that if Offers was available in the top 200 metro markets, sellers of 2.75 million homes would be eligible, and based on numbers from Phoenix, 15-35% of these would request an offer. This could bring in revenue of approximately $0.5-1 billion with very little associated cost.

Figure 3: Zillow Segment Revenue

(source: Created by author using data from Zillow)

As Zillow's Homes segment expands, the company's gross profit margin is declining rapidly, although the operating profit margin has not been greatly affected. This trend will continue as the Homes segment expands, and Zillow's future profitability will be largely dependent on the unit economics of iBuying.

Figure 4: Zillow Profit Margin

(source: Created by author using data from Zillow)

Zillow's move into iBuying is also dramatically expanding the company's balance sheet as it holds housing inventory financed with debt capital. Zillow's success in iBuying will be highly dependent on its ability to rapidly turn its inventory over and avoid inventory write-downs due to falling house prices.

Figure 5: Zillow Asset Turnover and Return on Assets

(source: Created by author using data from Zillow)

iBuying is a difficult business from a working capital perspective as sellers are paid upfront and then Zillow must hold housing in inventory for an extended period as it prepares the home for sale and tries to sell it. This dynamic can be seen in Zillow's rapidly expanding cash conversion cycle.

Figure 6: Zillow Cash Conversion Cycle

(source: Created by author using data from Zillow)

Zillow has rarely managed to achieve positive free cash flow, and its large negative cash flows, as it expands its iBuying business, are likely a cause for concern for many. Given the rate at which revenue is currently growing, I do not currently see this as a concern as positive cash flows will come once growth moderates if they are able to make the unit economics work.

Figure 7: Zillow Free Cash Flow and Growth

(source: Created by author using data from Zillow)

Zillow takes an approximate 7% fee for their iBuying service and must cover their expenses from this, plus any appreciation that may occur in the home price. This leaves little margin for error in accurately estimating a home's price, managing renovation and selling costs and quickly selling the home. So far, Zillow is making small losses on their homes segment which is not too concerning as there are likely to be teething issues, and Zillow is yet to reap the benefits of economies of scale.

Figure 8: Zillow Homes Profit Margin

(source: Created by author using data from Zillow)

Investors should look for a flat or declining trend in Zillow's iBuying costs relative to revenue as the business scales to give an indication of its viability. If home acquisition costs begin to increase, this may indicate Zillow is having to increase its bids due to competitive pressure in the market. Renovation costs should decline as Zillow scales and obtains more favorable pricing with contractors as long as they are able to buy homes in good condition. Holding costs and selling costs should decline through economies of scale, diversification of risk by expanding geographically, and by reducing the time required to sell homes.

Figure 9: Zillow Homes Expenses

(source: Created by author using data from Zillow)

The thin margins in iBuying mean that price estimates must be extremely accurate, which reduces the pool of potential homes. Homes which are unusually expensive or cheap, older homes and homes with unusual features are likely to be excluded due to difficulties pricing them. The median error for Zillow's price estimate of on market homes ranges from 1.2% in Washington DC to 3.6% in San Francisco. It is unclear how Zillow's price estimates compare to competitors, but given their experience in the area, they are likely to be a leader.

Figure 10: Accuracy of Zillow Real Estate Price Estimates

(source: realestatedecoded)

Zillow must also not lose focus on its core IMT segment, which is an important source of cash flow and leads for the other segments. Growth in traffic to the website has slowed in recent years, although this is likely due to Zillow reaching market saturation. Zillow's Homes segment puts it into direct competition with agents which has the potential to alienate IMT's consumer base. Given how dominant Zillow is in the lead generation market, though I do not believe this is a major risk. Zillow's focus on providing agents with high quality leads through excess volume from Zillow Offers is also likely to ensure IMT remains successful.

Figure 11: Zillow Website Unique Visitors

(source: Created by author using data from Zillow)

Competitors

Zillow's main competitor in iBuying is Opendoor, which was founded in 2014 and is the world's largest iBuyer. So far, Opendoor has raised $1.3 billion in equity and $3 billion in debt, and its last funding round valued it at $3.8 billion. Opendoor is significantly larger than its competitors, and it is still growing rapidly as it expands into new markets. Phoenix is currently the largest market for iBuying with 6% of all transactions by iBuyers and 3% by Opendoor.

Figure 12: Opendoor Net Revenue

(source: iBuyer Report)

It is not known if Opendoor is currently profitable, but their unit economics appear reasonably attractive. These economics are likely to continue to improve through scale and more efficient operations. For example, housing days in inventory declined from 140 in 2015 to 90 days currently.

Figure 13: Opendoor Unit Economics Phoenix

(source: mikedp)

Although Opendoor is currently the largest player in the market, Zillow is gaining rapidly as a result of its strong brand name, dominant position in lead generation and larger financial resources.

Company

Equity Raised (USD)

Opendoor

1.3 billion

Zillow

7.1 billion (market capitalization)

Offerpad

150 million

Knock

60.5 million

Redfin Now

1.8 billion (market capitalization)

Table 1: iBuyer Equity Raised

(source: Created by author using data from iBuyer Report)

Figure 14: Phoenix iBuyer Mark Share 2017-2019

(source: iBuyer Report)

Figure 15: Number of Homes Purchased in 2018

(source: iBuyer Report)

I believe Zillow's iBuying business will approach the size of Opendoor's in the next few years, and competitive pressure between the two is likely to increase as growth in the iBuying segment slows. If this occurs, home sellers are likely to benefit, and iBuyers could potentially bid all of their profits away. In this scenario, profitability will only be achievable through better data analytics, superior operational efficiency, and cross selling value-add products and services.

Figure 16: iBuyer 2018 Revenue

(source: iBuyer Report)

Although Zillow is achieving rapid growth its home purchasing strategy appears to be different to Opendoor and OfferPad and could potentially be problematic. Zillow is purchasing more expensive homes than competitors which experience shows are more difficult to value and take longer to sell.

Figure 17: iBuyer Median House Purchase Price 2017-2019

(source: mikedp)

Figure 18: Zillow Home Purchases and Unsold Inventory

(source: mikedp)

I believe the iBuying market will be fragmented somewhat geographically as the business does not naturally lend itself to scaling across cities and regions. Low profit margins in iBuying mean that profits are only significant at scale, and this is likely to result in a fairly consolidated market, and at this stage, it appears as though Zillow and Opendoors will be the winners.

Valuation

Given the rapid growth that Zillow is likely to achieve over the next 3-5 years, the low margins of their business, even if it is successful, make it difficult to value Zillow with any confidence. The rate of growth, eventual market penetration, profit margin and time taken to achieve profitability will all significantly impact the value of the company. I have estimated an intrinsic value for Zillow of $85 per share, although I do not think this number is particularly important. If the iBuying business model is feasible, then Zillow is undervalued. If it is not, then Zillow is overvalued. If Zillow can effectively monetize their large volume of high quality leads, they are undervalued. If they cannot, they are overvalued.

Disclosure: I am/we are long Z. 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.