Zillow - Fantasy Will Ultimately Give Way To Cold Hard Reality: $20 Price Target

Summary

• I value Zillow's three business segments for a combined $20/per share.
• Homes, its house-flipping business is worth $0 per share at best.
• I believe the Mortgage segment is also worth $0.
• Zillow Media, its real estate web site, is a real business that I believe is worth $20 per share.
• I have a strong sell rating on Zillow.

Zillow is truly a magical stock. It has doubled this year, and tripled off its bottom. And why not? Zillow lost money the last five years, but Wall Street analysts (Yahoo Finance) expect…another loss this year (-$0.40) and another loss next year (-$0.13). Yes, Zillow could beat these estimates and break even or eke out a small profit. But even Zillow’s most ardent supporters can’t argue that this year’s rally is due to near-term earnings.

Yes, Zillow is a magical stock in a magical investment environment. A time when a strong internet presence – and yes, Zillow has that – is enough to let investors dream big dreams.

But the fact is that those ultimately dreams have to be about earnings, however far in the future. Owning a stock is owning a piece of a company, and the reason you and I like owning pieces of a company are that we share in its earnings stream. So this, my second report on Zillow (the first was Zillow: The Stock Is A Zell) returns to the question of whether Zillow’s three businesses can generate sufficient profits over the long run to justify its current price of $87, no less a higher price. My conclusion is again is that the prospect is quite slim indeed. I therefore reiterate my zell – sorry, sell – call on Zillow. And not just a "somewhat overpriced" sell. My target price is a dazzling 77% below its current price. Magical times create some fantastical creatures.

What is a Zillow?

For newbies to the stock, a quick review of those three businesses:

· Homes, which buys and flips homes.

· Mortgages, which originates home mortgage loans.

· Zillow Media (my name), which refers prospective homebuyers and renters who visit its web site to realtors for a fee.

Let’s check out their potential stock market value.

Zillow Homes’ value - $0 a share.

Here are Homes’ financial statements since it got going in earnest in 2019:

Source: Zillow financial reports

Three data points stand out like sore thumbs:

1. $490 million of losses in just six quarters! Big losses today must mean big profits down the road, right?

2. The gross margin is awfully narrow. The gross margin represents, to the best of my understanding, the sale price Zillow achieves, less (A) the purchase price, (B) needed repairs/renovations and (C) the interest carry on the home while in inventory.

3. Overhead costs seem very high. Why does it take roughly $400 million a year to buy and flip?

It looks to me that Zillow Homes will certainly lose money for the next few years. Can it ever break even, no less make the massive amounts of money the stock price implies? Unlikely, because of gross margin challenges.

Somehow Zillow needs to buy cheaper or sell dearer. But the more likely outcome is narrower margins. More competition brings lower profits. There are already over 80,000 realtor organizations whose job it is to increase the pool of buyers. The rise of “iBuyers” adds to the competition. iBuyers include bigger names like Zillow, Redfin, Opendoor and Offerpad. But the ads on a Google search also popped up Prestige Home Buyers, WeBuyHouse, Fast Cash for Your Home, Upnest, Clark and Homelight. There are even services to help you choose the right iBuyer! All of these new competitors threatens profit margins.

Could the one-click appeal of iBuying be so compelling that a large number of home sellers will accept thousands of dollars less in sale proceeds and give that money to the iBuyer? I will defend the millennials to say that only a few will be so careless with their finances.

Net/net, I cannot see how Homes adds to Zillow’s stock value. Give it a $0. It should surely generate losses for the foreseeable future, in my opinion. And the likelihood of compressing gross margins suggests that even if Zillow can bring this business to profitability, it will be modest. As likely is the possibility that Zillow will shut Homes down at some point.

Zillow Mortgage’s value - $0 a share.

This table compares Zillow Mortgage’s profits since inception with national loan origination volume:

Sources: Zillow, Fannie Mae

Another money losing business to date, although a piker at $58 million of cumulative losses compared to Homes’ $490 million. Mortgage lending is fiercely competitive, and subject to severe cyclical risks. Look at the national loan origination numbers in the table and you can see the volatility. Home sales are seasonal, peaking during Q2 and Q3. And refinancings are wildly cyclical based on interest rate changes.

The drastic decline in interest rates engineered by the Federal Reserve this year obviously set off a refinancing boom. Fannie Mae believes the boom peaked during the June quarter. Within 6-9 months after a mortgage rate drop, the great bulk of homeowners seeking to refinance at that rate will have done so. Fannie Mae’s therefore expects refinance volume to decline this quarter and next quarter. The next refinancing wave may be a long way off. The 10-year Treasury rate is down to 0.7%. Yes, it can go lower, but not by much.

This scenario is nasty for the mortgage origination business. Following the last four refinance booms, origination volume declined on average by about 40%. This one should be no different. The sudden excess loan processing capacity in each prior case caused significant losses and widespread bankruptcies. Again this time will likely be no different.

Circling back to Zillow, its mortgage businesses managed to only break even during possibly the last big refi boom in a generation. This Q3 it may even turn a small profit. But after that? Duck.

Finally, an interesting data point. When smart businesspeople are selling, smart investors are selling too, not buying. In the mortgage business, nobody has done better than Rocket Mortgage (also called Quicken Loans). I will put their management team up against any in the US. Rocket successfully navigated through the Great Recession and four refinance cycles, all along taking share from the country’s biggest banks, all as a private company. Yet a few weeks ago Rocket went public. Management is selling. Do you want to buy as a Zillow shareholder?

I don’t. I value Zillow Mortgage at $0.

Zillow Media’s value - $20 a share.

After a tough decade, Zillow Media is now a real business earning real money. But the business has its limits. Zillow Media earns it money as an advertising outlet for real estate brokers, primarily for home sales. As such, Zillow Media is ultimately limited by realtors’ ad spend, which in turn is limited by realtors’ commissions, which in turn is limited by home sales. A present value model for Zillow makes assumptions for those three items, as well as Zillow’s market share of the ad spend, its profit margin and a discount rate to present value future income. This table shows those numbers for 2019, my estimates for 2025 and then any assumed changes beyond 2025:

The home sales growth rate assumes a 1% annual increase in the housing stock, 3% home price appreciation per year and a steady rate of turnover of homes.

The average realtor’s commission of 4.5% is about the current rate, but competition created by the internet is likely to reduce that level over time. So I’m being friendly here.

The average realtor marketing spend of 6% is about what industry leader Realogy spends.

Zillow’s market share is Zillow Media’s revenues from home sales (excludes apartment rentals) as a percent of the estimated realtor marketing spend. By this measure Zillow Media’s share increased from 14% in 2015 to 25% this year.

The profit margin is Zillow Media’s after-tax profits as a percent of total revenues. Note that Facebook’s most recent profit margin was 28%, so I give Zillow Media full credit for success.

The discount rate of 10% is relatively low, suggesting strong confidence that Zillow will deliver on the above assumptions.

Popping these assumptions into Excel’s net present value generates a $20 per share value. That’s it. Could I get $30 with more optimistic assumptions. It’s nearly impossible.

Summing up. And how much fantasizing is needed to prove me wrong.

So far I've got $0 + $0 + $20 = $20. Excel also tells me that Zillow’s current stock price of $87 is more than $20. Zell. Or sell. This is a seriously overpriced stock.

But how did Zillow get to $87? Is there a non-magical forecast of net present value per share (NPV) that makes any sense?

If Zillow Media grows its market share by 7% a year rather than my assumed 2%, then it will own 100% of the realtor marketing budget in ten years. That still only gets my valuation for Media to $35 a share, but we're closer, right?

Mortgage is just too small and farfetched to generate material value. So it's up to Zillow Homes. If Zillow Homes:

• Takes its flip volume from maybe 7,000 annualized at present to 30,000 by 2024.
• The gross margin holds at 4%.
• Overhead expenses fall from $450 million a year at present to $300 million by 2023. Pretty impressive considering that I'm assuming a four multiple volume increase, but...

All of these rosy scenarios add - are you sitting? - $4 per share in NPV! So we need far more serious fantasizing. Ready? Let's do it:

• Ratcheting up the flip volume to 50,000 while holding operating expenses at $300 million takes the NPV to $12 per share.
• Doubling the profit margin to 8% by 2024 gets $30 per share of NPV for Zillow Homes. Now keep in mind that at present the difference between the sale price and the buy price is the 4.5% commission. Under this new more efficient system offered by Zillow Homes, the difference increases to 8%! Can Zillow find 50,000 home sellers willing to accept $15,000 less in proceeds from their home sale?

Even with two seriously unlikely events - Zillow Media captures a 100% market share and Zillow Homes extracts far more money from home buyers/sellers than they pay at present - I still only get $65 per share!

We need more. Zillow Streaming? Zillow Motors? Zillow toothpaste? I'll leave this fantasizing to you. I'm tired. And selling.

Disclosure: I am/we are short 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.