Back in Q2, I titled my analysis of Zillow’s earnings, “Going All In” and wrote:
When Rich Barton took (back) over as CEO of Zillow earlier this year, I wrote a Red Dot and titled it, “The Return of the King.” I didn’t realize then that the king was not just a fighter, but a gambler. With giant brass ones. After the Q2 earnings results, I know that now.
Zillow’s Q2 earnings came in more or less as I expected: huge spike in revenues, but an even larger spike in expenses, resulting in absolutely astronomical losses. Seriously. I had to find a way to format the percentages as I’ve never needed the thousands separator in percentages. But I needed it this quarter. Net loss widened by 2,227%? I mean… what?
Zillow’s Q3 earnings show us all what going all in looks like. And I’m glad I found a way to include the thousands separator in percentages, because I needed it again.
I think broadly speaking, both the bulls and the bears will find something in the earnings report to delight them. The bulls can point to absolutely massive growth in revenues and an impressive performance in the (still) core IMT business, while the bears can point to the even more massive growth in net loss and chortle.
As is typical when Zillow reports, there was a lot there, especially in the earnings call as management discussed what happened, what they’re seeing, and what they’re thinking. It was a really open and transparent discussion, which is par for the course for Zillow.
My take on Q3 is that Zillow is in the midst of a BCG 2×2 Matrix exercise and a delicate point (in a good way) in the transition from Zillow 1.0 to Zillow 2.0. What they’re doing is not a test to see if they want to do it at all, but a test kitchen to see which recipe they want to deploy. The analogy will make sense, I promise.
So let’s get into it.
The Numbers
The Q3 numbers were just astonishing, whether you were a believer or an apostate. Let’s start with the Financial Highlights:
Yes, that really does say 3,390.9% increase in revenues YOY. And yes, Virginia, that really does say that losses widened by 13,040.0% from 2018. Seriously, at one point as I was formatting the worksheet, I burst out laughing just because the changes were so dramatic as to be amusing.
On the one hand, revenues more than doubled driven primarily by Homes (Zillow’s iBuyer business) that grew the aforementioned 3,390% YOY. $384.6 million in revenues from Homes now makes that segment the largest part of Zillow.
On the other hand, losses went from a measly $492K to $64.6 million, an increase (decrease?) of 13,040%. I mean, you kinda have to laugh a little bit, right? Especially if you’re a Zillow bear like Steve Eisman who thinks going into the Homes business is nuts. Those kinds of losses make it seem like Eisman is a savant. I imagine the bears are going to have a field day on Friday.
On the other other hand, the “core” IMT business grew by 7% in all of its sub-segments: Premier Agent, Rentals and Other. Even Mortgages grew substantially. And most impressively, if you’re a Zillow bull, the profit from IMT segment grew by 565% YOY. Now that’s really impressive, given that Zillow has been pivoting away from being an advertising business to being a principal in the marketplace for quite some time now.
But on the fourth hand (not impossible if you are a Hindu deity), it is now crystal clear to anybody who has eyes that traffic growth has topped out. Yes, Zillow grew by 5% YOY to 195.6 million average monthly unique users, but given that there are only 350 million people in the U.S., that might just mean 5% of the people got new smartphones during the quarter. Then again, on Kali’s fifth hand, that does mean that Zillow utterly and completely dominates online real estate with Realtor.com posting 71 million average monthly uniques and Redfin coming in with 36 million. The competition is not even remotely close.
Small telling detail: prior reports always had IMT above Homes on the table; Q3 has Homes above IMT. Strikes me as a fine example of what Zillow 2.0, as Rich Barton calls it in the Shareholder Letter, really means.
Segment Details
If we dig a little bit deeper, there are a couple of interesting nuggets as well. Here’s the Segment Results of Operations:
The couple of interesting things here are:
Homes has a 3.6% gross margin, before all the other expenses pile on to create a massive loss. (But see below for more on that.)
IMT’s performance looks even more impressive, as that unit is bringing in more money, at lower cost of revenue, and cutting $5 million from G&A while holding costs down on the other expenses. We’ll come back to IMT, as I think Q3 was actually more about IMT than it was about Homes.
Mortgages unit is spending rather a lot of money, resulting in massive losses even as revenues grew substantially. But its gross margins are still over 80%, which bodes well for the long term. We’ll touch on this below as well.
Homes Unit Economics
The data I’ve been waiting for is the unit economics of Homes, since Zillow is unique in releasing that information. Why, it’s almost as if Zillow has nothing to fear from anybody by releasing that data….
First off, Homes is growing at a torrid pace. That’s obvious. 1,211 homes sold in 3 months is seriously no joke; Zillow is about a quarter of the way to the goal that Rich Barton announced of selling 5,000 homes a month.
But what caught my eye are the increases in costs on a per-home basis. It doesn’t really make much sense to me that renovation costs would go up 6%, or that holding costs would rise by 17%, on a per-unit basis. There was no real exploration of that, so I just don’t know. My expectation would have been that those costs would drop over time as the Homes team got more experience, built out infrastructure, refined processes, automated things, etc. etc. So it is a bit worrisome that those costs are rising, not falling, on a per-unit basis.
Then again, I don’t know exactly what went into those costs going up. Maybe moving into new markets, especially higher end ones like Denver and Southern California, spikes those costs. Maybe they include a bunch of putting carpet and lawn guys on payroll. Who knows? Maybe Zillow will explain that some day.
But as a result, pre-interest return on a per-home basis went negative for the first time since Zillow started publishing unit economics. In Q1 and Q2, the amount that Zillow made was tiny, but at least Zillow didn’t lose any money per home buying and selling them before interest came into play. In Q3, Zillow lost a small amount of money on each home sold.
Then again, Zillow reported $13.8 million as gross profit for Homes so I’m not even sure what exactly counts in its Cost of Revenue calculations.
Still, I’ll be using these numbers to redo my analysis of iBuyers for Q3 and Q4 (until Zillow reports Q4 with new unit economics numbers).
Lastly, as I did in the Q2 writeup, because Redfin complains about the accounting that Zillow uses to compute gross profit, here’s what the two iBuyer programs look like if we move Holding Costs and Selling Costs into Cost of Revenue:
I’ll repeat what I said about Redfin: you can’t lose to Zillow on buying and selling houses. Conversely, given that Redfin does have a 14 year head start on Zillow in actually operating in the marketplace, and hundreds of employee agents with boots on the ground, the fact that Zillow appears to be beating Redfin at the buying and selling game is that much more impressive.
Flex is Not a Test; It’s a Test Kitchen
The central theme of the Q3 earnings call was IMT and Flex. Rich Barton even led off the prepared remarks with talking about IMT and Flex, trying to reset expectations on the Street about just how fast Zillow is going to pursue a total change in its core business model for ten years.
My personal theory is that Zillow was surprised at the performance of IMT and Premier Agent in Q3. I mean, IMT lost money in Q1, brought in $13 million in Q2 (which was very nice indeed, but hardly earth shattering), and had more or less stopped growing in 2018. Remember that Flex was launched in October of 2018 and before that, Premier Agent 4.0 (which was substantially similar), to try and deal with the lack of growth in Premier Agent. I think that Zillow management was surprised to see IMT turn in $42 million in earnings. There just was no historical precedent to that kind of performance.
And the reasons for that excellent performance appear to be (a) cost control, which leads to productivity, and (b) customer retention. Both are sustainable. Q3 doesn’t look like it was an anomaly, just a lucky quarter, and then Q4 and beyond go back to meh. It looks like IMT can be a real profit driver for quite some time.
It makes sense to not mess with that. So Rich and crew walk the messaging back a touch, while saying they’re not walking back the messaging a touch, repeating time and again, “hey, it’s just a test.” They talked about how Flex is about 5% of MRR (monthly recurring revenue) from the current MBP (Market Based Pricing) model.
I don’t buy it, not fully.
I buy that Zillow realized that with the pivot to Zillow 2.0, they can start harvesting IMT instead of investing in it. I buy that Zillow sees no reason to kill the cash cow just yet, but I don’t think Flex is just a test to see if it’s something Zillow might want to do at some point down the road. I think it’s more of a test kitchen scenario, where Zillow is trying out different recipes in different markets to see exactly what kind of cake they want to bake. They’re gonna bake a cake; they’re just trying to figure out what kind of cake.
I’ve already written volumes on why Flex is not just a test, and why it is the future of IMT, but in as few words as I can, Flex is necessary to Zillow if it is going to control the consumer experience. You cannot tell your customer what to do, how to do it, when to do it. You can tell your vendors (call them partners if you wish) what to do, how to do it, and when to do it. Zillow recognized long ago that it cannot control its consumer brand if it doesn’t control the consumer experience, and losing the consumer brand is fatal.
This feels a lot like a classic BCG 2×2 Matrix exercise to me. Zillow has a wonderful Cash Cow in IMT; it has a giant Question Mark in Homes. That question mark appears to be trending towards becoming a Star, but it’s going to take time and a boatload of money to get there. But a cash cow is only a cash cow if it’s delivering cash, and IMT did not have a wonderful history of delivering cash. It did in Q3, and in such a way to make one believe that it can keep on delivering into the near-term future.
That’s a wonderful problem to have, and I think Zillow is smartly taking advantage of it, walking back some of the messaging on Flex without saying they’re walking it back.
But nothing I’ve seen or heard makes me think that Flex is just a test. There is no “maybe” in my mind about whether Zillow eventually transitions to Flex. It’s just a matter of what Flex ultimately looks like in terms of pricing, availability, kinds of agents they pick as partners, and a thousand other details besides.
Not a test, but a test kitchen.
Go back and re-read the Q2 analysis and the various Red Dot reports on Zillow for more.
Tidbit: Mortgages
There wasn’t very much conversation about Zillow Home Loans, the new mortgage division. Rich mentioned Rian Furey and Libby Cooper, and towards the end of the call casually mentioned that they’re doing some localized tests of integrated Zillow Homes Loans. Allen Parker, CFO, mentioned mortgage sort of in passing, saying they “continue to put the tech and the stack in place” to grow that business.
All true. And really, with all the excitement around Homes and IMT, it’s easy to sort of ignore Mortgage. I just want to point to what I’ve already written about Zillow and its longterm mortgage play. Then just point out a couple of things.
One, Rian Furey and Libby Cooper both come from Impac Mortgage. As I pointed out in a past Quick Takes, Impac is not just a mortgage company. It is the industry leader in non-QM lending.
So maybe you can draw some conclusions from that factoid. I know I do. Go back and reread the mortgage post if that would be helpful.
Two, Zillow is investing in Mortgage. Sales and Marketing expenses just about doubled, Technology spend is up 65%, and G&A nearly tripled. I imagine they’re not doing that just for funsies. So I expect Mortgage will make real noise sometime in 2020, possibly in 2021, as Zillow fully integrates Offers with Home Loans and starts doing some really innovative things with seller financing, private label MBS, and so on.
Not a Scene, An Arms Race
One last thing to mention in the way of conclusion. Here’s Allen Parker during the call:
We ended the quarter with $2.3 billion of cash in short term investments on our balance sheet, included the proceeds we raised in our recent $1.2 billion convertible debt offers. [Emphasis added]
At one point in the earnings call, Rich Barton waves away issues of competition, saying, “The amount of iBuying in totality is tiny. It’s really tiny. Most people don’t know about it, okay? It’s really, really small and so I don’t, we have not entered a phase in this iBuying thing where the competitive dynamics actually matter all that much.”
I thought to myself, it’s easy to say that when you’ve got $2.3 billion in cash sitting in your war chest and just about all of your current competitors are still playing a bit of small ball.
The effort to change the way that we all buy and sell houses is chaotic, and there are plenty of players who take all kinds of angles on that question. But of all of the companies doing that, it sometimes seems to me that only Zillow is seeing that as what it is: an arms race. Opendoor likely sees it the same way, and they have the headstart on iBuying as the company that pioneered the modern approach, but they’re so far behind Zillow in CAC that they’re now the ones who have to make some big bets and swing for the fences.
What I think I most love about the big debt offering and stacking up cash is that it says to me that Zillow is strategically sound. I think they’re seeing the big picture as it is, and they’re predicting the future because they intend to bring it about. To do that, $2.3 billion is just the starting point. They get it, and it isn’t clear to me that others in the industry do.
All in all, I think Q3 was a very strong quarter. It continues the theme of going all in, posting huge revenue gains and ginormous losses. The investors that will stick with them have the intestinal fortitude for the big bet and the roller coaster that it will involve. The bears will find much in this quarter to bolster their arguments as well. So something for everyone.
-rsh
