Zillow (NASDAQ:Z) operates real estate and home-related websites that act as a platform to connect consumers with real estate agents. The websites have your usual bells and whistles such data on ranges of home prices, pictures, etc. The company operates multiple brands such as Zillow, Trulia, Mortgage Lenders of America, StreetEasy, HotPads, Naked Apartments, RealEstate.com, and Out East. These websites basically convert views into sales leads for real estate agents, and the company monetizes those leads in a variety of ways. This basically represents the Internet, Media and Technology ("IMT") division of the company.
IMT segment revenue is generated from the sale of advertising services and marketing software and technology solutions to real estate agencies and other professionals. The four revenue categories within the IMT segment are Premier Agent, Rentals, Mortgages and Other. Premier Agent, Rentals and Mortgages are mostly advertising revenue sold to agents, property rental offices, and mortgage lenders on a cost per impression/cost per lead basis. The other segment of the business focuses on technology solutions and is a much smaller portion of the business roughly 13% of revenue in 2018. It's somewhat disappointing to me that the technology solutions portion of the business is such a small portion of the business as the company spends so much on Technology and Development (390 million in 2018 for the IMT segment and 352 million in the 9 months in 2019 total).
Source: Zillow 2018 10-K
For all intents and purposes, I consider the Premier Agent, Rentals and Mortgages to be virtually identical and representing the mature advertising related business. Looking over at similarweb at the company's analytics, I can see the company is doing reasonably well. The real estate listing website space is fairly crowded and, in my view, entrenched companies would have really good economies of scale.
Given that the company is already at scale when it comes to the platform as a software/advertising business, it came as a surprise to me that the IMT segment is still unprofitable. A software platform business has been around for a few years now, so the costs of technology and development should be decreasing as the company slowly shifts to maintaining the existing technology (vs. needing to program more features). Sales and marketing expenses for the IMT segment is also unusually high for a tech firm at 534 million, close to 42% of segment revenue. This would be understandable if Zillow is an enterprise software company and you need a sales team to close big clients, but for a platform company, this is truly baffling to me. The main point of owning a platform is the ability to properly scale (thus using economies of scale to reduce operating expenses), at this point, Zillow is already among the top real estate websites for consumers and should be a cash-generating business.
My guess is that the availability of other platforms such as craigslist and other dedicated real estate websites makes it hard for Zillow to charge real estate agents to be on the company's platform since it also needs those same agents on the platform to attract views.
Source: Zillow 2018 10-K, author emphasis
Beginning in April 2018, Zillow Offers provides started buying homes in certain metropolitan areas using its own capital. When Zillow buys a home, it makes certain repairs and lists the home for resale on the open market. The company also started originating residential mortgages to consumers through its newly acquired subsidiary Mortgage Lenders of America. The company hopes to capture the difference between what it buys the home for and what it resells at the open market. Buy low, fix it up a bit, then flip it. Fundamentally, it is no different than being a house flipper (and a bank, given that it also does mortgage origination).
This pivot is a bad idea. Historically, Zillow has been a technology firm with its focus on building a technology platform. Now, it is moving away from being a tech firm to being a Real Estate Asset firm. The keys to success as a Real Estate asset firm are completely different from that of a tech firm and Zillow has no competitive advantage in this space. In order to succeed as Real Estate firm, Zillow would need to 1) properly assess and buy houses at the right price (below market value and covering any repair costs) as well as 2) have the operational capability to properly conduct the necessary repairs and manage a portfolio of houses.
Zillow says it is targeting a 1.5 percent profit margin on every house sold. That is a very small margin of error, and Zillow needs to sell its homes quickly to limit the amount of time it's on the hook for mortgage payments, home-ownership-association fees, and insurance premiums. Zillow would also have to manage risk among its portfolio of houses as it would take some time to offload those assets. Finally, rational homeowners would probably do some sort of price comparison between Zillow, its start-up competitors, and traditional real-estate brokers leading to a more efficient market at the end of the day.
Why would a nondistressed seller sell their home" to Zillow, Eisman asked. "There's only two possibilities for that. Either, one, Zillow has mispriced the house," he said. "Or there's something wrong with the house."
Even assuming that Zillow has somehow developed an advanced predictive algorithm to properly buy houses and can outsource repairs and management to a well-run partner, Zillow's expansion efforts for this business would still be constrained by capital requirements. Unlike software that you develop once then can sell an infinite amount of copies, Zillow can only buy and sell as many houses as its balance sheet can manage. Based on the company's 2019 3Q 10-Q, the company has about 2.3 billion cash on hand, a portion of it financed with long-term debt (total debt of 1.4 billion). This means the company has enough "dry powder" to execute its strategy but one has got to wonder if the juice (low-profit margins and operational risk) is worth the squeeze.
It's hard to do a valuation when you don't agree with the company's strategy. But let's assume I am some big-shot hedge fund, and I can take a controlling activist position in Zillow, how much would I pay? Well, first I would completely halt Zillow Offers, return capital back to shareholders and bring down IMT related expenses to a reasonable level. The IMT segment has 1.3 billion in revenue in 2018, assuming with my business prowess, I am able to raise net income margin to 25-30% that's roughly 325 million to 390 million in net income.
At 198 million shares outstanding and a P/E of 15 that translates to a share price target of 24.6-29.5 which is well below its current stock price. I wouldn't short Zillow as the company still has a lot of cash it can burn and hype can carry the stock to new highs, but this is an easy avoid for me.
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