Why I'm Long Opendoor Stock Through Zillow's Implosion

Summary

• I make the case for holding Opendoor stock despite Zillow's recent pains in the iBuyer market amidst housing price headwinds.
• Opendoor has demonstrated a distinct advantage in profitability on its home flipping compared to Zillow. I dig into why that may be.
• Due to the low-margin nature of the business, a small difference in gross margins indicates vastly different turnover efficiencies. Opendoor has historically been the better run business.
• Q3 may well be a difficult quarter for Opendoor too; that said, the long-term narrative is intact and the financial trends show sufficient indication of the business model working.
• OPEN is substantially undervalued. It is a high-risk, high-reward play. We are long at the Abstract Portfolio.
• Looking for a portfolio of ideas like this one? Members of The Abstract Portfolio get exclusive access to our model portfolio. Learn More »

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Zillow (NASDAQ:Z) posted its Q3 earnings results and they were not good. Zillow Offers, the company's iBuyer vertical, posted heavy losses. The company decided to exit the entire iBuying vertical after recording a -20% gross margin for the segment in Q3, citing excessive housing price volatility and a lack of predictability in the market to justify continuing with the opportunity.

This development in the industry would have undoubtedly induced some questions among Opendoor (NASDAQ:OPEN) shareholders. After all, Zillow and Opendoor have been considered to be direct competitors vying for similar opportunities. As an investor in OPEN myself, I thought I'd have a crack at an analysis.

I came to the conclusion that OPEN offers compelling risk/reward potential; I'm long OPEN.

Opendoor vs Zillow

Opendoor and Zillow are competitors. Opendoor is notable for basically inventing the iBuyer category - the business model where the company itself buys and sells houses against homeowners while charging services fees across the client base.

Zillow, on the other hand, has historically operated as a consumer internet company that offered other real-estate services since 2004 but didn't quite operate the iBuyer model. In recent years, Zillow moved to enter into the iBuying space, possibly seeing Opendoor as a threat or a disruptor. As mentioned, they got crushed last quarter and they'll be exiting entirely.

Find out more in Zillow's Q3 Shareholder Letter.

Now, this information may lead to two very contrasting opinions:

If Zillow could not succeed, why should Opendoor? Perhaps the iBuyer business model simply does not work. Opendoor will be crushed too.

OR

Zillow lacks innovation and couldn't pull off its risk management in the face of housing price headwinds. Opendoor has less competition now, and they're going to grow unobstructed because they have superior technology/data science/risk management, etc.

I'm paraphrasing, but I noticed that both views have been shared across investment communities and the Twittersphere after Zillow's quarterly earnings and disappointing strategic changes. I suppose Opendoor shareholders would harbor some of the following questions:

• Can Opendoor actually succeed in the long term?
• Is Opendoor exposed to the same housing price downside forces as Zillow?
• Will Q3 reveal that Opendoor holds a pile of marked down home inventory?

In my view, Opendoor is indeed exposed to both short and long-term volatility, and very exposed to black swan risks. For instance, the company was hit with a brick (financially speaking) during COVID through 2020 and had to seek out Social Capital Hedosophia's SPAC transaction to get to the public markets.

To start hunting for answers though, it's worth starting out with data. Some points of data indicate that Opendoor simply does a better job through its business execution compared to Zillow and others.

Mike DelPrete has an excellent website dedicated to real-estate tech at mikedp.com. Here are a few data-points sourced from a recent publication by Mike that shed some light on recent trends:

• In Phoenix, as of October, Zillow's listings were priced at a median of -6.2% below what they were bought for. On comparison, Opendoor's median price was 1% higher.
• In Atlanta, as of October, Zillow's listings were at median of 1.3% above what they were bought for. By comparison, Opendoor's median price was 6.5% higher.

Source: "Priced To Sell: Zillow's Inventory Problem", mikedp.com

Note that Phoenix and Atlanta represent two of the largest markets for iBuyers.

Now it's important to note that the iBuyer business is a tiny-margin business. Revenues are recorded as the full sale values of the houses sold, while Cost of Revenues incorporate the prices the same homes were bought at.

So when there's a 4%-5% point differential in housing price gains/losses, you're looking at two companies that are operating at drastically different efficiencies for home flipping. This is not a new temporary data point. It is also evident by comparing Opendoor and Zillow's gross margins for 2021 thus far:

• Opendoor posted ~13.3% gross margins for the first half of FY2021.
• Zillow recorded ~8.8% gross margins on their Zillow Offers segment for the same period.

Source: Opendoor Q2 21 Financial Supplement, Zillow Q2 21 Financial Supplement

When the housing price trends reverse sharply after a very hot run, these gross margins are also set to trend downwards. For example, a 13.3% margin for Opendoor might head to -0.7%, while an 8.8% margin for Zillow might fall to -5.5%. In this situation, Opendoor is a business that will burn some cash in a downturn while Zillow is a business that shall burn a lot of cash. Of course, there's a lot of nuance in this matter as both companies use machine learning algorithms and heavily data-backed strategies to make their home purchase decisions wisely to squeeze out better results.

As it played out, Zillow's gross margins were abysmal for Q3, recording -20% on the gross margin for the three months. September particularly saw a distinct spike in house prices and Zillow ended up purchasing right through the trend when there was a price cliff waiting for them around the corner.

Meanwhile, Opendoor is expanding to Canada and hasn't had any remarks on housing headwinds yet. They're not obligated to say anything through a press release anyway before the next earnings. Their Twitter account, however, has presented more than a little optimism on November 3rd after Zillow's results:

Source: Twitter

Was Q3 a Zillow problem or an industry-wide problem? It's hard to tell, and it could have even been a mix of both. Zillow's earnings call admirably focused on the company's shortcomings and inability to operate with the desired results. Management made some general statements on the housing market and its unprecedented changes over the last two years: particularly the pandemic, the freezing of the housing market, and serious supply/demand imbalance more recently. It's obvious that these challenges were faced by Opendoor too if they were market-wide, but Opendoor may have just dealt with the same challenges a lot better.

Before jumping into Opendoor's Q3 expectations, a conclusion one can draw from comparable historical and alternative data is that Opendoor has some sort of edge that is manifesting in much higher profitability. This is worth talking about.

What Is Producing The Opendoor Edge?

The company was crafted and iterated over through most of the last decade with a focused view to bring the iBuyer model to scale. One shouldn't be surprised if the team picked up some tricks along the way. The margin differential is indeed large, but I reckon that the company's risk management and superior decision-making (in hindsight) for purchasing the right homes at the right prices come down to the tech and the team behind the company.

Source: Opendoor Investor Presentation

CEO Eric Wu has a history of living and breathing real-estate tech for more than a decade and a serial entrepreneurship record. He's co-founded Opendoor after all and it's likely that he pioneered the model that we see today.

CTO Ian Wong previously served as the Head of Data Science for a little company called Square (SQ). If there's some black magic data science system that leads to a highly accurate pricing model for homes, Mr. Wong is likely the key guy behind it. It goes without saying that the ex-"Head of Data Science" at Square when Square was laying their foundations back in 2013 would have serious technical chops. A quick search on his LinkedIn profile would point towards his work at Square as an "Inference Scientist" and a "Professional Estimator". Those skills come in handy when your entire business model depends upon accurate estimation itself.

Source: Opendoor Analyst Presentation, Nov 2020

So when the bearish thesis revolves around the concept that Opendoor is simply a money-burning mass home-flipper, I harbor skepticism since the unit economics have historically showed a difference in value creation. Surely, if both Zillow and Opendoor were merely flushing cash at scale in a free market, then what's causing the separation in results? Operating in this space requires tight execution of risk and inventory management, though the Opendoor home-flipping system could be a far more technically sophisticated one. They have proprietary hyper-local data being fed into an algorithm that keeps improving across time. Ideally, any iBuyer player should have a quick and rapid inventory turnover. It is not an easy business to crack and it's worth noting that Opendoor has been doing this for years longer than new entrants or pivots like Zillow Offers. Thus, when the stress test of Q3/Q4 2021 finally arrived, I'd wager that Opendoor was better prepared for it.

If Opendoor's gross margins stabilize towards even just ~8% over the long-term, I reckon we still have a viable business. Think about it; an opportunity in the $1T+ for home sales turnover across the United States every year. If Opendoor is a tech platform that can scale large enough, there is a reasonable chunk in gross profits to be realized; all with centralized tech operations that take up less of an operating expense margin as the opportunity scales. OPEN may demand a tech enthusiast's optimism and a long-term view whilst looking at this business as a venture capitalist more so than a value investor. For now, though, it seems to be best of breed with high-growth market capture.

Thoughts On Opendoor's Next Earnings Release & Downside Risks

Opendoor's Q3 results will be released on November 10th, less than a week from now.

Since Zillow experienced housing market headwinds in Q3, it is likely that Opendoor experienced them too. A lot of the earnings results depend on the decisions the algos made and if the company ramped up their purchase volumes through the peaks of September, when prices particularly rocketed up. Mike DP's data posted above indicates that the company is on a much healthier trajectory compared to Zillow with a substantial cushion to absorb falls. One thing that's particularly hard to determine is the extent to which the market has already factored in the downside, which may vary from bad to really bad.

If I was forced to make a forecast, I would predict a mid-single-digit gross margin for the coming quarter, if not a gross loss. This is a high-risk market after all and having thousands of homes on your balance sheet for a quarter where downside volatility hits the fan is definitely risky. Should the market not price these Q3 or Q4 headwinds, OPEN's price action could be choppy and there may be big drawdowns from here, even after the 15% drop. That may require a further evaluation of the thesis though an overreaction may present a buying/adding opportunity. Should Home Sales and Revenues come in significantly higher than guidance/expectations, then we could see an upward surge instead that balances out the gross margin shock.

Beyond this Q3 earnings, it's yet again difficult to predict how the broader housing market can trend over the next six months to a year. A tightening on the fiscal/monetary front and a Fed taper may pressure the housing market into further declines in prices. Given this situation, Opendoor may choose to ramp up its growth slower than expected or optimize for fewer, but faster inventory turnover transactions. The future sales and profits may be pushed further into the future.

Despite these potential downside risks and lack of predictability, is it still worth holding a position? I think the answer is yes.

At the risk of sounding blasé, it's wiser to focus on the company through a long-term lens against this shaky unpredictable short-term. For the winding road may twist, but if the destination is the right one, any semblance of minor overvaluation won't quite matter against the massive opportunity. Investors should clearly ask: can Opendoor win over the long term?

The Long Term

In my view, the long-term narrative still stands strong as Opendoor operates as best-in-class among the competition on profit margins. They're disrupting the real-estate market by providing better value to homeowners who participate in the process. The platform has gone well past product-market fit and thousands of homeowners are transacting through Opendoor at an accelerated rate every quarter. And why would they not?

The antiquated system of going through a broker, staging visits, multiple evaluations, fixing stuff, documents galore, and strategically hunting for your next house while risking losing out because you don't get your cash in time. It is a pain. The markets continue to underestimate the products/services that remove friction from our lives. Few processes can have as much friction as buying or selling a house through a real estate agent who earns a chunky service fee that almost relies on a lack of transparency. If you receive a competitive offer that matches the market price, the agent's rate, and takes all that trouble away, the decision should be easy. The customer satisfaction as of the last year can be highlighted by the excellent Net Promoter Score of >80. Excellent customer experiences and network effects plant seeds for further avenues of monetization and upsell later.

Source: Author, Data from Opendoor Filings.

Every quarter, more houses have been sold than the preceding quarter's inventory since the company went public. If we do see a Q3 hit, it should still be comforting to note just how fast Opendoor has been flipping these homes historically.

While historical margin expansion looks nice given the tailwinds-driven market, it's worth noting how profit margins are influenced by the lag and scale of inventory sold as sales ramp up. Should the company sell off 7,000 houses as opposed to 3,500 in a near-future quarter, the contraction between Adj. Gross and Adj. EBITDA will be more significant. So despite the gross margins contracting to single-digit figures, Adj. EBITDA may still be positive.

In other words, the unit economics work at scale. This isn't a perfect representation of a profitable path given the past few quarters have been very kind to iBuyers, but it is good enough as an indicator for me.

Source: Author, Data from Opendoor Filings.

One might scoff at non-GAAP margins, but should this home turnover trajectory continue, the operating expenses will shrink drastically as a percentage of revenues. It is still early stage and Opendoor's sales are in hyper-growth mode against a $1T sales opportunity. The economies of scale, especially on the bottom lines can well work with a ramp up.

Importantly, the company has strategically raised enough capital that provides them with excellent balance sheet ammunition referred to as the "buybox" to expand their business and operations from here at an exponential pace. One of the largest competitors threw in the towel, and that could translate to higher pricing power being exercised down the line.

Valuation

OPEN also happens to be undervalued by a substantial margin, at least in my view.

In Q2 21, Opendoor did $1.2B in Revenues on 3,500 homes sold. With a Q2 inventory more than twice that size, it is likely we're looking for more than $12B in sales in the next twelve months (NTM) accounting for reasonable growth amidst headwinds. Apply a rather conservative 8% gross margin and the NTM EV/Gross Profit of 15x. For a high-growth company with a leading competitive position and an unlimited runway, this is cheap. A closer multiple ought to be 25x in my opinion, translating to a ~66%+ upside from the current $20 price. If the company ramps up faster than this implied trajectory, there's even more upside.

Risks

• The iBuyer model doesn't work despite the scale.
• Downside home-price action may lead to a culling of growth and margins.
• Competition from direct iBuyers and peripheral real-estate tech disruptors such as Offerpad, Zillow, Redfin, Compass, Inc.
• Financial risks based on the exposure to volatility; home inventory risk exposure.
• Black swan risks and credit events.
• Adverse macro effects and regulatory policy.
• Systemic market risks; OPEN may experience substantially higher volatility and drawdowns as a high-growth money-losing business.

Ending Notes

Opendoor is the original innovator of the iBuying model and likely has the best chance to progress through their opportunity and make it work long-term. Zillow's exit translates to less competition for Opendoor and more pricing power in competitive markets. Q3 headwinds could impact Opendoor this quarter as the housing market has cooled off, but investors should stay focused on the long-term narrative as short-term action is hard to predict. Unit economics have improved and larger scale itself can tighten up profitability to produce a very real and functioning business. If Opendoor does reach mass scale (~15,000+ homes sold a quarter), I think there'll be little stopping them from winning a whole lot more.

If high-risks are present, so are the rewards for investors that take the stance of the iBuyer model working over the long-term. Opendoor seems to be the best expression of this disruptive trend amidst competition and has the numbers and the competitive advantages to back it up. At an NTM EV/Gross Profits of 15x, the stock is undervalued. The Abstract Portfolio is long OPEN.

Disclosure: I/we have a beneficial long position in the shares of OPEN, SQ either through stock ownership, options, or other derivatives. 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.