Investors in Zillow (NASDAQ:Z) are not having a great time right now as the stock has fallen nearly 70% from its high in February earlier this year. With its iBuying program in shambles, we have to figure out what is the value of its underlying core business. Is this a great opportunity to buy right now or is this simply a falling knife we should all avoid? Stripping out iBuying, I'm a big fan of Zillow’s high-margin internet/software business which appears to be reasonably priced, and possibly undervalued with some room for upside. However, Z might experience some choppiness in the near term during the wind-down of its iBuying operation, as well as continued housing industry headwinds.
Before we jump in to buy the dip, we must first understand the underlying concerns that led to poor investor sentiment over the past year and where Zillow stands moving forward from here.
Source: Google Finance
Overview of Zillow
Zillow is the No.1 online real estate marketplace in the United States offering home buying, selling, renting, and financing services to customers with speed and ease. Personally, I like to think of it as the ‘Google of real estate.’ Its website also provides a free tool to estimate the market value of homes using its proprietary formula “Zestimate”.
iBuying Program
Three and a half years ago, Zillow announced its iBuying program, with the aim of becoming a market maker, painting a beautiful growth story for investors. Zillow’s iBuying program, Zillow Offers, allows homeowners to sell their homes without a broker or real estate agent with ease and convenience. It was going to reinvest its cash profits into growing gross profit, which management believes will ultimately deliver great returns for investors in the future. Fast forward to 2021, the program, however, was not well received and Wall Street hated it. With management guiding unit economics coming down, in the short term it's as good as deploying capital without a return and destroying value in the process. As a result, investors lost faith in Zillow’s management and wanted to get out before the company lost more money. Despite this, Zillow decided to double down on its iBuying business, acquiring ShowTime, which is a market leader in home-showing technology, for $511 million in cash earlier this year. Zillow’s share price continued plummeting over the next few months despite reporting very strong results in Q2 2021 earnings with over 70% revenue growth.
Wall Street Was Right
The iBuying program turned out to be a very bad idea. On Nov 2, Zillow announced that it will be winding down its iBuying operations after racking up over $1 billion in losses over 3.5 years. I mean, at least they tried… right? This resulted in a massive selloff which now presents itself as an opportunity for investors to buy into what’s left of the company.
So, what now?
Stripping out its iBuying operation, let us take a look at its core business and find out how much its underlying business is worth. Aside from its iBuying program, Zillow currently generates revenue from its Internet Media & Technology (IMT) segment and its Mortgages segment.
I quite like Zillow’s core business and I think it has a pretty solid moat. Its IMT segment consists of its Premier Agent marketing operation & ‘Other IMT revenue’. Rentals, advertising, and business technology solutions for real estate professionals make up the remaining bulk of its IMT segment. Despite winding down its iBuying program, Zillow remains an important tool and marketplace for homeowners, buyers, and real estate professionals. Its core business is still a strong internet/software business with high, durable margins and they have built a very strong brand over the years. Currently, Zillow is the go-to option for property owners or real estate agents/brokers looking to list a property in the US.
According to IPM statistics report, 29% of all real estate website traffic is on Zillow. According to a Statista report on the most popular real estate websites in the US as of Oct 2021, 3 of the top 10 most-visited real estate websites -- Zillow, Trulia and HotPads -- belong to Zillow Group. In fact, on Google, more people enter the search term “Zillow” than “real estate”.
Source: Created by author using data from Statista report.
Market Opportunity
The U.S. housing market has been really hot and since COVID-19 emerged, home prices have skyrocketed across the nation. The supply of U.S. homes for sale is near record lows, and the gap between supply and demand is widening.
Currently, the United States is short 5.24 million homes, based on Realtor.com’s research. The situation is exacerbated by supply chain disruptions over the past year and labor shortages throughout the pandemic. Median sale prices of homes in the U.S. skyrocketed while the total number of homes for sale decreased 17.8% yoy.
Source: Redfin U.S Housing Market Data.
This leads me to believe that there is still a lot of pent-up demand for homes. When the housing market cools down with home prices stabilizing and more new homes being built in the future, I expect higher transaction volumes and more homes available for sale when supply eventually picks up. However, I don’t expect this to happen soon as there are still major ongoing supply chain bottlenecks and issues with labor shortages to be addressed. While there are near-term cyclical pressures on some of Zillow’s marketplace businesses, with strong traffic in IMT marketplaces, they are well-positioned to benefit as rental and new construction supply and demand imbalances normalize, and advertising pressures subside in the future.
Based on data from the National Association of Realtors, 51% of buyers found the home that they purchased on the internet and 28% from real estate agents. At the top of the seller funnel with over 227 million average monthly unique users, Zillow is currently the undisputed market leader in the space and I believe Zillow is in pole position to capitalize on the pent-up demand and increasing supply of homes available for sale in the future while achieving higher monetization across the business. Zillow also recently just closed the ShowingTime acquisition, which is a way for them to create a touring reservation system and improve the experience for movers and shoppers.
With the large audience that Zillow has built, I see significant growth opportunities as they only have an approximately mid-single-digit market share (4-6%?) of industry transactions despite being used by every homebuyer in some capacity. Furthermore, with nearly 10 thousand homes on its balance sheet right now, Zillow will have over $5 billion in cash to pursue other growth verticals or repurchase its own shares post iBuying wind-down.
With such growth opportunities fueled by additional pent-up demand, I believe Zillow can improve conversion and leverage that growth to maintain high margins in their core business.
Financials And Valuation
According to its Q3 2021 letter to shareholders, Zillow’s IMT segment revenue grew 16% yoy to $480 million for the quarter, relatively strong compared to the industry growth estimated at 9%. Adjusted TTM EBITDA for the IMT segment has grown to over $836 million, representing a 248% increase from 2018 over the same period. The IMT segment consists of Premier Agent and Other IMT revenue. Its Mortgages segment revenue grew 30% yoy to $70 million with total loan origination volume increasing 115% in Q3 yoy.
Source: Created by author using data from Q3 shareholder letter.
At $58 per share, Z is trading at a $15.6 billion enterprise value, which I believe is a decent deal for its core business. The company is guiding towards $1.9 billion in revenue for its IMT segment and adjusted EBITDA of $833 million. Based on the company’s slightly conservative outlook, it is currently trading at 9.5x 2021 IMT Gross Profit and 19.5x 2021 IMT EBITDA. With over 44% EBITDA margins and solid top-line growth, Zillow’s core internet/software business looks like a decent deal at these valuations. Assuming its IMT segment grows 15% in 2022 while conservatively bringing EBITDA margins down to 40%, Zillow is trading at 18x 2022 Core EBITDA.
I will provide a brief comparative valuation between some of Zillow's competitors including Opendoor Technologies (OPEN), eXp World Holdings (EXPI), and Cushman & Wakefield plc (CWK). Note that I am stripping out iBuying and only focusing on Zillow's core business, hence figures used for Z are based on its IMT segment only.
Source: Created by author using data from Seeking Alpha.
However, management expects its iBuying operation to incur a loss of $348 million and an additional loss of $265 million in Q4 related to homes Zillow has committed to purchase. They also expect impairment and restructuring costs of ~$230 million throughout winding down its iBuying operations extending into 2022. Assuming they lose ~$1 billion during the wind-down process, if we simply focus on its core business (pro forma iBuying wind-down) and run conservative estimates (low-teens growth) into a DCF model, I still get a $70-75 price target, representing a ~24% upside from here.
Source: Author's DCF Modeling
Zillow’s Display of Confidence
On Dec 2, Zillow announced significant progress towards winding down its iBuying program and has sold over 50% of the homes it expected to resell during the entire wind-down process. The company is raising its Q4 2021 Homes segment revenue outlook to a range of $2.3-$2.9 billion from $1.7-$2.1 billion. The CEO Rich Barton stated that "... no longer operating Zillow Offers will allow us to have a more capital-efficient balance sheet and business moving forward.”
For what it’s worth, Zillow has authorized the repurchase of up to $750 million in share buybacks using the cash from the wind-down. However, I’ll be taking it with a grain of salt seeing as how insiders have also recently sold some shares themselves.
It’s also worth noting that on Nov 24, TRC Capital offered to purchase up to 2 million Class C shares at $61.20 per share. However, Zillow recommended its shareholders reject TRC Capital’s offer and not tender their shares. Perhaps management strongly believes their shares are undervalued after the recent selloff. The founders have more skin in the game than anyone else and that’s a great sign. Insiders are highly incentivized to ensure Zillow performs well and that’s exactly the ideal setup you want.
Source: Company's filings
Risks
Company-specific risks
I would like to see if Zillow can inflect profitability in its Mortgages segment in the future and reduce the reliance on its IMT segment which mainly comes from the agents/brokers who pay to be Premium members. These agents/brokers may look to other platforms for better deals and think twice before signing up for the Premium status should there be increasingly strong competition in the future. I also expect revenue growth to slow down in the near term due to skyrocketing home prices and limited housing supply during this tough time.
However, I like to be on the bullish side and counter that Zillow has built a pretty strong moat and solidified itself as the No.1 player in the online real estate marketplace. I think Zillow has become such a powerhouse that consumers would demand that their for-sale homes be shown on Zillow. If agents/brokers choose not to pay to be Premium members, they might lose out against their peers and lead to a potential loss in sales. Personally speaking, if I was an agent/broker I would gladly pay a small fee if it meant increasing my chances of selling the property quicker/at a better price.
Zillow's Credibility
The iBuying operation was a huge disaster for Zillow, racking up substantial losses and losing credibility in the process. For years, Zestimate - Zillow’s estimate of a home’s value, was one of the company’s most publicized but also most controversial offerings. Consumers may start losing faith in Zillow’s home pricing technology. If Zillow miscalculates the value of its own home purchases, how can it calculate the value of others’ homes? With home prices skyrocketing since COVID-19 hit, it has probably been the best home flipping market ever (aside from the 2008 period) and yet Zillow is exiting the space with huge losses. Calling its iBuying operations a failure is simply an understatement.
Systematic Risks
Turbulent times ahead: The Federal Reserve announced at its December meeting that facing the threat of runaway inflation, they may end its pandemic-era bond purchases as early as March next year, effectively raising interest rates. This is bad news for stocks, especially for growth stocks, depending on how aggressively the Feds decide to taper its QE program. We could see another market correction in the near term should the market throw another ‘taper tantrum’.
The Bottom Line
Its core business is still a very strong internet/software business with high, durable margins with solid growth. Its Premier Agent business has outgrown the industry in each quarter and management expects the business to continue to do so in its Q4 outlook. At $58 per share, Z is trading at a $15.6 billion valuation, which I believe is a decent deal for its core business. Based on the company’s outlook, it is currently trading at 9.5x 2021 Gross Profit and 19.5x 2021 IMT EBITDA. With over 44% EBITDA margins and solid top-line growth, Zillow’s core internet/software business looks like a decent deal at these valuations.
However, I am not in a hurry to buy either. Although I don’t believe in timing the market, I think Zillow will experience a lot of choppiness in the near term during the winding down of its iBuying operation, exacerbated by headwinds including interest rate hikes, buoyed home prices, labor shortages, and poor investor sentiment. However, while there are near-term cyclical pressures on some of Zillow’s marketplace businesses, they are well positioned with strong traffic in IMT marketplaces to benefit as rental and new construction supply and demand imbalances normalize, and advertising pressures subside in the future.
Issac Choo
Retail investor from Singapore who loves valuation. Believes in value investing and finding growth companies for the right price. Long-only for the most part.
Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, but may initiate a beneficial Long position through a purchase of the stock, or the purchase of call options or similar derivatives in Z, ZG over the next 72 hours. 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.
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