[VIP] Zillow, Q4/2019: Turn the Page

In the Q3/2019 writeup, I wrote that Zillow is not experimenting, but trying to pivot with great delicacy:

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.

With Q4 and the full year 2019 results now in the books, it seems pretty evident that they have navigated quite a bit of the treacherous waters with the cash cow Premier Agent business roaring back to life. At the same time, looking at the 2019 results as a whole, it is plain to see that the pivot is complete. Zillow is no longer a portal, but a market maker. The question is whether they can now execute on the (new) core business efficiently, and of course, profitably.

All signs from the earnings call, of course, is that Rich Barton has the accelerator pinned to the floor. The enormous gamble he took last year when he came back as CEO appears to be paying off in at least one half of the equation (Premier Agent) and while the market maker business continues to pile up giant numbers both black and red, it seems clear that on that side of the house, Zillow is at full throttle.

Let’s get into it.

[Disclaimer & Disclosure: I have mentioned before that my wife now works for Zillow. But we have a pretty strong Chinese wall between us, do not discuss anything that is not public information from Zillow, and all that follows is my opinion based solely on already public information.]

The Numbers

For Zillow, like it was for Redfin, Q4 turned out to be a surprisingly great quarter. Surprising because that’s normally the slow season in real estate. Nonetheless, Zillow’s performance was impressive as hell.

By now, we’re used to the commas in percentages coming from Zillow. But even so….

Revenues nearly tripled, mostly because of the Homes division going from $41.3 million to $603.2 million, an increase of 1,359%. Of course, Zillow lost more money for the quarter — $101.7 million vs. $97.7 million — but it’s been a very long time since Zillow’s investors cared about net income. There’s no reason why that would change after Q4.

But the real news, and one that Wall Street analysts are focusing on, is the Premier Agent business roaring back to life. It seems that Q3 was not a one-off fluke, but the start of a turnaround. Here’s Rich Barton during the prepared statement portion of the earnings call:

Starting with Premier Agent. While we entered 2019 with significantly heightened partner churn versus the prior year, we have started 2020 with some of the best retention rates we’ve seen in recent history. Our connection rates are on the rise. And through our work to partner with the best agents, we saw customer satisfaction continue to increase during the quarter.

This has been driven primarily by solid execution as our team has heightened its focus on making connections between our customers and our best partners, which contributed to strong Premier Agent revenue growth. I want to commend Susan Daimler, who leads our Premier Agent business and her entire extended team for, first, stabilizing this core business and then leading a reacceleration of it. As you can see in the Premier Agent same-store sales chart in our shareholder letter, when we back out the impact of our 2019 Flex tests, we ended December with 12% year over year same-store sales growth in monthly recurring revenue, up from 5% at the end of September. Looking down on our Premier Agent business from 50,000 feet, our goal is to: A, increase our big C conversion rate from visitor to transactor; and B, increase our revenue and profit yield per lead.

We’re going to talk more about this below, but damn, that’s a great quarter. On a YOY basis, IMT went from losing $57.5 million in Q4/2018 to pre-tax income of $36.2 million, a 163% improvement. I do hope Susan Daimler, who Rich calls out, got a nice big fat bonus. Greg Schwartz might have started the turnaround back in Q3, but she carried the momentum forward for sure.

Segment Details

Let’s dig a bit deeper.

The 3.6% gross margins for Homes, before all the other expenses pile on to create massive losses, remains for Q4 as it was in Q3. But one thing I found interesting is the amount of investment Zillow is making into Homes in terms of expenses. Total expenses for that division is about $120 million (not taking cost of revenue into account there) vs. roughly $30 million in Q4/2018. That’s straight investment into overhead, technology, people and marketing. It’s also almost a third larger than Q3’s expenses at around $92 million, which in turn was about 25% more than the $73 million in expenses from Q2.

No wonder Homes keeps posting monster losses along with monster revenues. It’s making gross profits, with a thin but detectable margin, but Zillow keeps expanding, hiring, and spending to keep growing that business.

In terms of the superstar of the quarter — IMT/Premier Agent business — I also wanted to note that Zillow cut expenses in Sales & Marketing by over $10 million, and Technology and development by $4 million or so, even as G&A grew by $5 million. It seems pretty clear to me that Zillow is no longer investing in IMT; yes, it keeps spending serious money on it, but it feels more like maintenance mode rather than growth mode. To me, this feels like Zillow has turned to taking profits from IMT.

Homes Unit Economics

Every quarter, I wait for the unit economics of Homes, since Zillow is unique in releasing that information. Once again, I’d like to thank Zillow for being so transparent; it really helps us to understand what might be going on with that most important of businesses.

With almost 2,000 homes sold in Q3, we’re talking about 57% growth over Q3… it’s full speed ahead. Revenues went up by almost 57% as well to smash through the half-billion dollar mark. So that’s all fantastic news for Zillow.

But the trend from Q3, where renovation costs and holding costs on a per-home basis increased continued into Q4. Just like in Q3, I don’t understand it. Renovation costs are up 16.5% from Q3 — which makes very little sense to me. Same with holding costs going up by 2%. Both should steadily go down as the Homes team got more experience, built out infrastructure, refined processes, automated things, etc. etc. So again, it is a bit worrisome that those costs are rising, not falling, on a per-unit basis.

And frankly, we’re talking about some dramatic rises. On a YOY basis, renovation costs are up 63% and holding costs are up 51% per home. I don’t know if this can be explained by the hiring and investment either, since renovations and holding costs probably aren’t related? Holding costs in particular is a mystery since Zillow says those are primarily “homeowners association dues, property taxes, insurance, utilities, and cleaning and maintenance costs incurred during the time a home is held for sale after the renovation period is complete.” Are those up 51% per home? Why?

Whatever the reasons, due to increased cost of renovations, holding costs, and interest expense, Zillow’s return before interest on a per-home basis went sharply negative, from ($113) in Q3 to ($1,512) in Q4. Now, keep in mind that Q3 was when pre-interest return went negative for the first time. Take interest into account (which is also up 86% YOY) and we have a not-so-great trend developing.

Nonetheless, there is no doubt that Zillow is not only not backing away from its iBuyer market making business like say Redfin has, but doubling and tripling down on it.

The Transformation of Zillow is Complete

Rich Barton mentioned Bob Seger’s classic hit, Turn the Page, during his prepared remarks:

And finally, we are in the process of galvanizing our employees around a new mission statement that animates our transition to Zillow 2.0. At Zillow, our mission is to give the people the power to unlock life’s next chapter. I’m going to do it again. At Zillow, our mission is to give people the power to unlock life’s next chapter.

It was meant to be more dramatic. Our homes represent distinct chapters of our lives, and we are building our technology, services and operations to make it easier to, as Bob Seger says, turn the page. In our quarterly shareholder letter, you will find a link to a short video you might enjoy watching you may enjoy watching about our new mission. It never fails to bring a tear to my eye.

We’re not surprised, of course, since we have been saying Zillow is transforming for a couple of years now. But the new mission statement, and the video make all of that crystal clear. So let’s watch that video:

This is more than just a feel-good PR video. This is a thunderbolt and a sign of things to come.

This is the first time I have ever seen a Zillow Advisor (Daizah Richardson) featured in any Zillow material. It’s the first time I’ve heard a Zillow employee say, “I think I was like his safe space. He was calling me with everything, even things I didn’t control. He was like, hey, I’m stressed out.” The only mention of a real estate agent is when Daizah says, “I set him up with an agent.”

That psychological role, that “make the stressful situation smooth” role is something that has been the province of the real estate agent since… well… the beginning of professional real estate in the United States sometime in the 1900s. It now belongs to Zillow. It is not by accident.

The Transformation in Premier Agent Is Almost Complete

Recall that the subheading of the Q3 report was that Flex was not a test, but a test kitchen, with Zillow testing out different recipes to find one that worked the best. And recall that my personal theory was that Zillow was surprised at the performance of IMT and Premier Agent in Q3 and that they saw no need to kill off the cash cow:

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.

With Q4 results now in, and IMT roaring back to profitability, it seems to me that Rich and team have found the right recipe. The quote above says that Zillow’s goals are (a) increase conversion rate from visitor to transactor, and (b) increase revenue and profit yield per lead. Then Rich says:

We believe there’s room for growth in both of these metrics. Our whole history with Premier Agent has been about continual business model innovation and testing in service of long-term growth maximization and customer satisfaction. Since introducing the Best of Zillow program and focusing Premier Agent on connection rates, service quality and most importantly, transaction conversion, we’ve seen significant improvements in our business fundamentals. Specifically, we’ve had to dig in on the capabilities and the productivity of our Premier Agent partners who are best at converting leads into transactions. [Emphasis added]

There’s the recipe, and it’s one we have been predicting on these pages for a few years now. But in Q4, we got a much fuller explanation of said recipe from Rich Barton:

And yes, I mean, all the inputs are improving on. On the high-performing partners question and providing more clarity. It’s really what it is. It’s unsurprisingly when we find partners who use our software, understand our system, we explain our system well, and they give the customer service and convert those customers into buyers, transactors of homes, those are the partners we’re looking for.

And we are testing and learning different things in different markets. It’s too early to make any broad generalizations to characterize what those partners look like, but we’re finding them. We’re finding enough of them. We’re seeing enough good results to continue to methodically expand our Flex tests.

I would say we’re looking for high-performance partners across the universe of PA 2. Flex is a very small part of the overall Premier Agent business. And the company’s new focus on the transaction itself and what it takes to get a customer into a new home has actually brought goodness to the whole of the Premier Agent business as well and taught us how to focus on what customers really want.

So not only is Zillow looking for top producing agents for IMT, Zillow is looking for compliant top producing agents who can follow directions.

This is so critical. So, so critical. So let’s say that again: So not only is Zillow looking for top producing agents for IMT, Zillow is looking for compliant top producing agents who can follow directions.

Zillow wants “partners” who use Zillow’s software, understand Zillow’s system, provide customer service according to Zillow’s standards and requirements (that’s what CSAT and Best of Zillow are all about), and have high conversion rates.

You know what that sounds a whole lot like? Redfin, without the overhead of salaries and benefits. In fact, it sounds a whole lot like the top producing agent teams that Zillow wants to partner with.

Now, I’m sure Zillow would not characterize what they do as “directions.” I’m sure it’ll be more like suggestions, best practices, recommendations, and so on. The agents are partners as far as Zillow is concerned, so Zillow would like them to be successful.

The point is that the “optimization exercise” that Barton mentioned over and over again works only if the agent is willing to go along with it. The suggestions and processes and best practices and so on exist for a reason: maximize revenue and yield from Zillow’s leads. Don’t follow those suggestions, drop below whatever Zillow’s standards are, and you risk losing those leads and potentially getting kicked out of the program entirely.

You can call it what you like, but my point is that it is now evident that Zillow doesn’t just want top producers who are go-alone cowboys. They want top producers who can follow “suggestions” and implement them effectively to optimize conversion, service levels, revenue and profit.

We have been predicting this for a while now, but it is refreshing to see it confirmed.

The Next Step in Domination: The Conversion Challenge

It’s not clear how many people picked up on the wealth of information flowing out from Rich Barton on this call, but… that’s why you’re a VIP subscriber, right?

The most amazing exchange took place during the Q&A. It’s worth reproducing in full, so prepare for the wall of text.

First, we have Rich Barton saying this:

Rich Barton — Co-Founder and Chief Executive Officer

And Justin, I think your last question, the last part of the question was about nudge and binary, is there something we can do to nudge? We think we have a ton of upside in mechanizing and professionalizing and applying software and modern technology to this nurture funnel to the sales funnel. And there has been a woeful, an embarrassing lack of tech investment in the real estate industry for pretty much its history. And so we’re waiting into — a gnarly problem, yes. But it’s a really fertile field.

There’s a long pent-up desire to kind of mechanize and professionalize through software this industry. So we have a lot, we see opportunity everywhere we look.

A bit later, we have a question from Brian Nowak, an analyst from Morgan Stanley, on the “blocking and tackling” required to make Flex go smoother. Rich replies:

Rich Barton — Co-Founder and Chief Executive Officer

Thanks for recognizing that, Brian. I don’t know if I had any other embedded references in there. Yes, on the kind of Flex friction points and what’s working and what’s not, I mean, we are really early, but we are discovering, as I said before, kind of a woeful lack of kind of application of software to better nurture and transaction experience in this industry. Traditional brokerages do not have and have not had big tech and dev budgets.

They have really, they just haven’t invested in technology. And that hasn’t really necessarily been their primary concern anyway because their business models have been a little different. So we’re seeing a tremendous amount of opportunity all along the nurture funnel of a customer. And as we find things, we’re automating it.

We’re finding the right partners who are better at converting these things. I mean, even basic things like drip marketing and email communication and when is the right time to call and when is the right time to send an email and don’t overwhelm consumers and bombard them with emails because they’ll get turned off, and they’ll go away. These kinds of some basic stuff that we have been in the tech business for a long time kind of take for granted, but we’re bringing those fresh skills to this industry, and we see a lot of opportunity.

This is the next piece of the puzzle for Zillow’s domination of the residential real estate industry. It feels like a deathblow to the ambitions of RE/MAX, Realogy, Keller Williams, and most of the traditional brokerages who have been busy talking about technology. KW went so far as to declare that they are now a technology company.

It’s one thing to play that game when the opponents are other brokerages. It’s a whole different deal when the opponent includes Zillow, who spent $477 million on technology and development in 2019 alone. KW wants to boast about the $1 billion budget for technology? Zillow already spent $1.7 billion in the last five years, and on current trends, I’ll bet Zillow will spend $500 million in 2020 on technology.

No wonder Rich Barton flat out says what we have been saying for years: there has long been a woeful lack of investment into technology in real estate. And now, it might be too late.

The type and quality of developers and programmers are different as well. Zillow isn’t competing against Realogy for coders and data scientists; they’re competing against Facebook and Amazon. RE/MAX simply can’t say the same, nor can any traditional real estate company.

And those are the people who are going to turn their attention to the “gnarly problem” of applying software and modern technology to taking a nurture funnel to the sales funnel? This is the company that’s going to work on the eternal problem of converting a lead into a buyer or seller?

Holy shit. If the game isn’t over, it’s in the 4th quarter. And the clock is ticking.

A Thought on IMT’s Profitability

Before we leave the amazing results that was IMT/Premier Agent, I wanted to point something out.

Zillow was rightfully proud of the growth in IMT, the profitability in IMT, as well as the “highest retention rates” they had ever seen. The question is, why and how?

I think the segment numbers give us a clue. In 2018, IMT lost $57 million; in 2019, IMT made $36 million. Huge improvement. But IMT cut $10 million from Sales and marketing YOY, and $5 million from Technology and development. That’s almost 42% of the improvement in profitability.

Most of the cuts in Sales and marketing came in Q4, since in Q3, Zillow spent $118.5 million but in Q4, Zillow only spent $108.3 million. Same with Technology: $94.7 million in Q3, and $88.9 million on Q4.

I think we see this trend continue, which means IMT’s profitability continues. Why?

Given what Barton made clear about the type of partners Zillow is looking for, we’re talking about a very limited subset of agents out there. Zillow no longer needs hundreds of salespeople making calls to agents to try and sell them Premier Agent. Zillow needs far fewer people who do relationship building and qualifications and coaching with the lucky few who have proven to be top producers who can follow processes.

Of course retention numbers are the best that Zillow has ever seen! By this point, any agent who is working with Zillow has gotten over the decade-long addiction to Zaterade (Zillow haterade) that is endemic throughout the industry. If the focus of the IMT team is not on sales but on training its partner agents to do the right thing, to use the right software (Zillow’s software, to boot), to do drip marketing, to do emails right, to call at the right time, etc. etc., then of course those non-hater agents will see success and success will drive retention and higher investment.

More and more of those agents and their agent teams are becoming more and more dependent on not just the lead flow from Zillow, but on the software from Zillow, the insights from Zillow, and the training and coaching from Zillow on how to succeed. Rich Barton’s words about basic skill sets that the tech business has taken for granted for a long time, which Zillow is bringing to the industry, are ringing in my ears. They should be ringing in yours as well.

Turn the Page

I think 2019 goes down as the year when Zillow turned the page on the real estate industry in the United States.

To be sure, the transformation has been going on for a while. I’ve tracked that change since sometime in 2015 when I wrote The Future of Real Estate, According to Zillow. In 2018, I wrote No Hat, Lots of Cattle: In Which Zillow Transforms. And now, all is proceeding as I have foreseen.

The plain fact that Zillow now generates more revenues from Homes than it does from IMT means that 2019 proves what I’ve written previously: Zillow used to be an advertising portal that did other things, but is now a market maker that happens to operate the largest portal in real estate. Wall Street analysts keep saying that Zillow’s core business is IMT; I don’t believe that’s true anymore. I believe Zillow’s core business is market making, and its very profitable side hustle is operating a portal and selling leads to agents.

But the TAM of agents to whom Zillow is selling leads is shrinking and continually so. Because they are no longer Zillow’s customers, but vendors or contractors — partners, to be nice about it. Increasingly, Zillow is looking for top producers who can follow directions, learn new skills that the tech industry has taken for granted for years, use new technology that Zillow will produce, and service Zillow’s customers in the right way. Flex is of course the ultimate goal of that, but even without Flex, Zillow’s agents will increasingly be Zillow’s agents.

Normally, a shrinking TAM is a major problem. But not here, because Zillow’s real TAM is no longer the real estate agent population, but the millions of buyers and sellers and renters. That means profitability on IMT will continue to improve as Zillow no longer needs to spend millions on sales and marketing to real estate professionals.

Layer on the lead nurture to lead conversion technology that Zillow will bring forth, and I suspect that more and more of the top producing agents in the United States will be, for all intents and purposes, working for Zillow. And given the zero-sum nature of real estate, that means that Zillow will become, for all intents and purposes, the largest and most important real estate company in the U.S.

Zillow Offers and Homes will continue to grow, as Rich Barton puts the pedal to the metal on that front, even if losses mount… because it isn’t about taking profits from Homes. No matter how much investors wring their hands and talk about profitability, there is a clear path to profitability if Zillow executes well with market making, ancillary businesses that come off of it (which Zillow talked about, but not in any detail, as things are very early). And the whole point of Homes is not to make money but to fulfill Zillow’s new mission statement: give the people the power to unlock life’s next chapter.

The transformation of Zillow is now complete. What remains is execution, and Rich Barton and team over at Zillow have not yet given any reason to doubt their ability to execute. What remains is transformation of the transaction experience for Americans, and the subsequent transformation of the industry as we know it.

Turn the page.

-rsh

PS: While I am a fan of the song, I’m too young to remember Bob Seger’s version which came out when I was two years old in Korea. So I’ll roll with the version I know, from Metallica. Video may or may not be safe for work, but it sure is more disturbing than Seger’s version.