Redfin - Two Negatives: Realty And Home Flipping - Don't Make A Positive

Summary

• Realtor Redfin is in a mature and heavily competitive business.
• In order to gain market share, Redfin crafted a money-losing business strategy that is hard to see turning profitable.
• On top of this problem, Redfin has added a second unpromising business - home flipping.
• Despite these problems, investor fantasies have taken the stock to a record high recently.  Fair value is probably below $10 a share.

A few weeks ago I wrote Zillow: The Stock Is A Zell. While researching it I took a cursory look at realtor Redfin (NASDAQ:RDFN). The more I thought about Redfin, the crazier the stock looked to me. I therefore added a Redfin short to my Zillow short. Then, in the best tradition of “Ready, Shoot, Aim”, I actually did some homework on Redfin. Here is the sum of my efforts. No, it’s not War and Peace. But it’s pretty damn close.

My summary argument for shorting Redfin:

• It is in a very mature and extremely competitive business.
• Like most other companies who attempt to rapidly grow in a mature business, Redfin crafted an unprofitable business model.
• Management then added another unprofitable business on top of its core unprofitable one.
• Overlooking this mess, investors have bought into a fantasy that has recently taken the stock to a record high and well over any reasonable valuation I can come up with.

The stock is $32 a share as I write this. In my opinion, fair value is no more than $10, and probably lower.

What the realty industry looks like.

The demand side. The value of homes sold in the U.S. is about $2 trillion a year. Big stuff. But housing is a mature product, so the growth rate of home sales can’t likely be much different from nominal GDP going forward. Let’s say 4%. Not exactly streaming or the cloud.

The supply side. Here is where all heck breaks loose. I’ll let Redfin’s 10-K do the explaining:

“The residential brokerage industry is highly fragmented, with numerous active licensed agents and brokerages, and is evolving rapidly in response to technological advancements, changing customer preferences, and new offerings. We compete primarily against other residential real estate brokerages, which include franchise operations affiliated with national or local brands, and small independent brokerages. We also compete with hybrid residential brokerages, which combine Internet technology and brokerage services, and a growing number of others that operate with non-traditional real estate business models. Competition is particularly intense in some of the densely populated metropolitan markets we serve, as they are dominated by entrenched real estate brokerages and are the primary markets for innovative and well-capitalized new entrants.”

Yikes. Zillow added that there are 86,000 real estate brokerages in the U.S. Talk about highly fragmented. Redfin has just neared a 1% share, enough to consider it a serious player.

Pricing is where supply and demand connect. So pricing stinks. Economic theory says that when modest demand growth meets huge supply, bad things will happen to pricing. Redfin says that annual real estate broker commissions are running at about $82 billion, or a bit over 4% of home sale volume. That percent should be declining.

Redfin’s angle on the realty business:

Redfin’s market share of home sale value was 93 bp during Q1, up from 67 bp in 2017. It has gained share through two main initiatives. The first is low commission rates. Realtors normally charge 2½-3% to represent either the buyer or the seller. Redfin says it charges 1½%, and only 1% if it represents both parties in the sale. To partly offset the lost revenue, Redfin has an unusual pay structure for its realtors. Rather than pay a portion of the commission to the real estate agent, who is often a private contractor, Redfin maintains them as employees, paying a salary and bonus.

Redfin’s second strategy is technology. The key technology is its web site. The site is now visited by 35 million people a month. Its web site gets four times the traffic of the next largest site, and twice as many visitors as the next four largest combined. A main attraction of the site is a home price estimator, like Zillow’s industry leading Zestimates. Redfin has also been working on streamlining the whole home sales process, from virtual tours through mortgage lending.

How has this strategy worked? The company says it is working great, citing this evidence:

• While Redfin’s real estate agents earn ⅓ less on each sale, they sell three times more homes, so they earn twice as much.
• Customer satisfaction is 18% higher, according to their survey.
• Their customers make $1,800 more compared to the listed price than at peer realtors.
• Redfin sells 76.6% of homes within 90 days, while peers sell 75.1%
• Etc.

But you’re not reading this article because you are a realtor, or a prospective home seller. You’re reading it because you’re an investor. How have investors done and are expected to do from this strategy? Not so well, as it turns out:

Source: Company reports, Yahoo Finance

From my experience as a stock analyst, this result is entirely expected. Sharply cutting price in a mature business will not generate enough extra sales to cover expenses, even when employee expenses are somewhat lower.

Redfin’s desperation heave – flipping homes.

Zillow’s decision to get into the home flipping game – I hesitate to call it a business – is a key reason for my short call on it. Likewise Redfin. The more I think about it, the dumber an idea it is. Three reasons:

1. It creates conflicts of interest. In Redfin’s case, the conflict is with its own employees; every home that Redfin buys and flips is one less commission that an agent could earn. (Zillow’s flipping competes with its realtor-advertisers.)

2. The competition is huge. First, remember those 86,000 realtors. Then consider the hordes of mom and pop home renovators. Then the professional home investors and renters. Finally, there are several other flipper companies. I discovered three private venture-capital darlings – Opendoor, Offerpad and Knock.

3. Home sellers aren’t that dumb. Say you’re an Amazon Prime member. You need reading glasses. The first pair you see on the site costs $19.95. One Click and done. No shopping around to see if you can save $2.00 on another site. Suzie Ormond might reprimand you, but you get it, right? Life’s too short.

Now you’re selling your house. You go to Redfin’s web site. It offers you $355,000. One Click and done? I don’t think so. Who isn’t checking to see if a $370,000 offer isn’t out there? $2, OK. $15,000? You’re putting in some work.

Add up my second and third points – aggressive buyers and sellers. Margins are thin, and getting thinner. So how will home flipping become a profitable game?

Redfin by the numbers

I showed you above that Redfin lost money the past five years and that those usually over-optimistic Wall Street analysts expect them to continue losing money this year and next year. How are they doing it? Let’s look at the numbers. We’ll start with realtor business indicators that Redfin thoughtfully provides:

Source: Redfin financial statements

What I see is:

Sales volume continues to grow strongly, at about 25% annually. National home sales over the past few years has been flat, so Redfin is clearly taking market share. Its volume growth is pretty much in line with its lead agent growth.

Average home prices are about 50% above the national average, due largely because Redfin’s markets are concentrated in major urban centers.

Redfin’s revenue per sales transaction is low.It averages a 2.0% commission, below the 2½-3% traditional fee. And Redfin gets only a small cut on referred business through its “Partners” program.

Redfin’s web site continues to gain traffic.Only about one-third of Zillow’s traffic, but as I noted above, way more than its nearest realtor peer.

We turn now to the income statement:

Source: Redfin financial statements

Points of interest:

Realtor revenues are growing at that same 25% clip, but…

…Realtor gross profits have been flat!Redfin reports gross profits as revenues less direct expenses related to those revenues, most importantly agent compensation. I add marketing expenses, which Redfin put down below in overhead, not direct expenses. Not only are many marketing expenses directly related to realtor commissions – Zillow finders fees, for example – but Redfin’s marketing spend has increased faster than revenues. Note that Redfin’s realtor profit margin squeeze is not surprising, considering growing industry competition. Peer Realogy has also experienced a profit squeeze the past two years. Finally, note that Redfin pulled back on its marketing spend this past Q1, probably in response to COVID, which artificially boosted Q1 gross profit.

Home flipping has earned no gross profit.And of course after allocating some overhead, is losing money. But who cares, right? Revenues are growing!

Overhead expenses continue to grow at a rapid pace, probably due to Redfin’s effort to be a technology leader in the realtor business, and to the build-out of a home flipping infrastructure.

Net/net, steady and growing losses.

Bottom line – There is no clear path to profitability.

Let’s fool around with an earnings model. Say that:

• Overhead expenses remain at $150 million.
• Home flipping and other earns $0.
• Realty holds its gross margin at 15%.

By using algebra, we can then answer the question of how much Redfin’s realty sales would have to increase to break even. The answer is (imagine a drum roll)…$1.0 billion! Double last year’s level. Could that happen while holding overhead expenses flat? Unlikely. So let’s say that sales would have to more than double. Redfin’s market share has been growing by 10-15 bp a year. Even with 5% home price inflation (unlikely), doubling commissioned earned will take five years plus.

Let’s get optimistic. Let’s say that Redfin figures out how to restore its realty gross margin to 20%. Now it would only have to increase sales by 50% to break even. So best case, say three years to break even. Just remember that we still must assume flat overhead costs, and the margin has been declining, but if one wanted to dream…

The stock will eventually reflect Redfin’s earnings problem.

How much longer will investors put up with Redfin’s losses? Especially when its home flipping expansion risks rising losses? The timing of a sea change in investor sentiment is impossible to predict. But the likelihood of that sea change occurring is high. And when it does, it is hard to see a bottom. Single digits for the stock is very possible.

If you own this stock, I suggest selling it. If you don’t, consider shorting it.

Analyst’s Disclosure: I am/we are short RDFN. 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.