One of my favorite moments in recent earnings calls came when Glenn Kelman, CEO of Redfin, used the phrase “delayed blast fireball” in an actual call. I ended up naming my writeup that, because as a former AD&D Dungeon Master, I got a real kick out of just how legit a nerd Kelman probably is. My second favorite moment, then, came during the Zillow Q1/2020 earnings call when Rich Barton tossed out that Zillow has something called Project Han Solo, and he extended the metaphor:
Inventory reduction is no longer our goal. We are actively planning to unfreeze Zillow Offers home buying. Internally, we call this Project Han Solo although our time spent in the carbonite will be shorter than Han Solo’s was.
I call that a victory for nerds everywhere… but… let’s be honest here. Star Wars always kind of, slightly, cool in a way that Dungeons & Dragons never was. It makes me think that Barton was the kind of super smart nerdy kid who still had a girlfriend in high school. And went to parties and stuff. In any event….
In the Q4 writeup, I wrote:
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.
The momentum from Q4 and all of 2019 carried forward into Q1 and the COVID crisis has accelerated long-developing trends. As I see it, while just about everybody else in real estate is struggling to survive — see my take on Realogy’s Q1 for example — Zillow is emerging as a fully armed and operational battle station. You can call Zillow the Empire, if you wish… but don’t forget that the Empire in Star Wars was the good guys, and the Rebel Alliance was actually the bad guys who kept slaves.
Let’s get into it.
Q1 was a record-breaking quarter… until COVID happened. The numbers rolling in show that clearly. So it is not a surprise that Zillow had a strong Q1:
The 500% increase in Homes revenue should knock your socks off, but most people won’t pay much attention to that. Part of it is because everyone knows (including Zillow) that the iBuying business throws off enormous revenues, but has equally enormous cost of revenues, leading to tiny margins.
It is the growth in IMT (some analysts keep calling that the “core” business, probably because Zillow management keeps calling it that, whereas it is actually the “cash cow” business in Zillow 2.0) that will attract much attention.
As Rich Barton said during his prepared remarks:
In all, the first quarter delivered strong results as we met or beat our outlook delivering record results across many measures, thanks to both strong execution and expense management. Our return to underlying double-digit IMT segment revenue growth and significant EBITDA margin expansion underscores the strength of our core business.
In Premier Agent, we have found meaningful success with our strategy of connecting more and higher-intent customers with our high-performing agents, which was illustrated by record performance in January and February. When our partners were most fearful in March, #BetterTogether discounts — better together is one of our core values — these discounts we provided to our Premier Agents helped these small business operators and buoyed retention rates through the most uncertain and volatile period. Without being naïve, I will say that #BetterTogether showed our partners how much they mean to us and that they appreciate it. This will pay dividends.
IMT continues the winning streak that began in Q3, under Greg Schwartz, but maintained under Susan Daimler. Her team delivered another impressive quarter, to be sure to the tune of 11% growth in revenues and 40% growth in EBITDA. Granted, most of the gains were already baked in by the time COVID hit, but as Barton said, Zillow retained a lot of their Premier Agents with the discounting (which will continue, as per the call) and earned quite a bit of goodwill from those agents who don’t automatically blame Zillow for all of life’s ills.
But as with all things Zillow, the really interesting stuff is in the details. So let’s look at some.
If we look into just how each segment performed in Q1, we see some interesting tidbits surface.
First, the fact that IMT’s cost of revenue only went up by 0.3%, while both Sales & Marketing and G&A attributable to IMT were cut pretty significantly, confirms my thesis about Zillow and IMT.
Here’s what I wrote in Q3:
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 Zillow is cutting investment and overhead into IMT says that they think of it as a cash cow. It’s hardly the “core business” of Zillow anymore. IMT delivered surprising results in Q3, continued it in Q4, and then did it again in Q1. If IMT really were the “core business” over there, I think we’d have seen more investment into it, whether in Sales and Marketing, or with additional bodies to grow that business some more.
Instead, we see cuts.
You know where we don’t see cuts? Zillow Offers:
- Sales & Marketing, up 243% YOY
- Technology and Development, up 165% YOY
- General and Administrative, up 63% YOY
That’s the Question Mark that Zillow is trying to turn into a Star, to fuel its next stage of growth and evolution.
From that standpoint, I found it interesting that Homes gained 20bps in gross margins. I understand that most people will only look at the ginormous losses it posted: $98 million in Q1, a 117% increase in badness.
During his earnings call, Ryan Schneider of Realogy made the point that Realogy was far better situated than “those trying to disrupt the industry with new capital-intensive but unprofitable ideas.” I see profitability to the tune of 4.9% on a gross basis, and that’s up from 4.7% a year ago. The unprofitable comes form gigantic spending on growth… something that no one else in the real estate industry appears able to do, including, of course, Realogy.
Mortgages continue to decline… but we’re going to return to mortgages down below. So let’s hold off on that for now.
Homes Unit Economics
Once again, Zillow’s transparency with its Offers business helps all of us — and if not all of us, at least my lonesome weird self — with actual data and information. But I wanted to do something a bit different here.
These are the unit economics from Q4 of 2018 onward:
The first thing to note is that Zillow Offers returned to the land of the positive gross profits, albeit tiny: $140 per home sold. Still a better result than Q3 and Q4 of 2019.
What’s more, even the $1,500 in gross loss per home taken in Q4 might have been fortunate, seeing as how Opendoor is facing potential extinction because of homes it held in inventory when the market paused, triggering likely buyback provisions in its financing arrangements.
The second thing to note, however, is an oddity. Zillow’s operating costs continue to rise even on a per-home basis. That makes no sense to me. Here are a couple of charts to illustrate what I mean:
Why are these going up? Shouldn’t they be going down over time, as Zillow gets more experience, more technology, more efficiency?
So I reached out to Zillow for answers, and got an explanation. I report, you decide whether you’re convinced or not.
First caveat is that we are very much still IN the process of our efforts to scale. It’s not that we aren’t getting better, but it is that you just look YoY, you gotta note that we were launching in lots of new, different markets last year with lots of local market nuances that drive costs and savings in very different ways. Which is why our stated goal is +/- 200 basis points while we learn/pilot/refine is important. And we’ve stayed within these publicly stated guardrails. Can’t stress this enough.
The spokesperson also said that YOY comparison isn’t great, because of the small numbers in Q1 of 2019. Zillow did expand from 8 markets to 24 markets, with significant variances in each market, so a Q/Q comparison may be more fair.
So here’s a chart provided by Zillow, using a % of revenue calculation:
I personally find it reasonable, but do think that Zillow has to show some real compression in operating costs this year. (Acquisition costs are a function of the market overall, and I don’t believe Zillow controls those.) All that tech spend has to start driving things like renovation costs and holding costs lower on a per-home basis, whether expressed as a % of revenue or as actual dollars, even taking variances between markets into account.
Finally, on Homes… the 117% increase (decrease?) in after-interest losses is not great news, obviously. But I did see that YOY, revenues went up 500% while costs and expenses together went up only 406%. Keep that up, and the losses will narrow and eventually become profits… which could get enormous.
That, my friends, is what I believe is called “path to profitability.” Zillow Offers has one, and it’s pretty clear and straightforward. It’s just a function of time and money being applied to things, and Zillow has plenty of money, and COVID just accelerated the timeframe.
The only real negative from my perspective is the relatively poor performance of the Mortgage unit. You all know that my thesis on Zillow is that it is a market maker, but its real profit center with the transformation of how we buy and sell houses is in mortgage. In a lengthy previous post, I wrote:
I think this is the ultimate long game for Zillow, for Redfin, for Opendoor, for Offerpad, and for any other market maker type of iBuyer. Sure, the laws and regulations are somewhat unsettled, but if anyone is going to test whether large institutions can do seller financing at scale using their own Loan Originators and using their own capital, I think Zillow will be the one to test it. The rewards are just too big to ignore.
And speaking of capital, it should be pointed out that any kind of successful loan sale or securitization should lower the cost of capital for the iBuyer significantly which makes that part of the business more profitable and even more cost-competitive. Given how much of a drag on Zillow Homes profitability comes from interest costs of its revolver, that could end up being a pretty big game changer on that side of the house.
The new equation for a fully-realized iBuyer model then is not “Buy Low, Sell High” on a home. It’s more like, “Buy home, convert it to a mortgage, sell/securitize mortgage, buy home, convert it to a mortgage… rinse, repeat” all the while making billions every time the cycle completes.
Unfortunately, there is one way in which COVID did not accelerate past trends, but instead disrupted them: the mortgage secondary market. Almost immediately after the various governments started instituting never-before-seen rules like mandatory mortgage forbearance, the secondary market went a bit nuts.
You can google all the commentary around that issue, but note that Greg Robertson and I recorded a special Industry Relations podcast episode to talk about those issues.
The long and short of it is, non-QM loans have more or less disappeared from the market. More attention is paid, perhaps, to the jumbo market as that really affects some parts of the country. But it is the impact on non-QM that really hurts Zillow’s plans (or at least what I think Zillow’s plans are).
Plus, the performance of the Mortgage unit in Q1 was… uninspiring, to say the least: revenue, gross profits, margins, expenses — it’s bad news all the way down the line. But then again, it is the smallest and newest unit, so mortgage won’t be front and center for a while.
What I’m sensing, reading between the lines of what both Rich Barton and Allen Parker said, is that Zillow is shifting its strategic focus away from transforming mortgages and towards transforming the buying experience. (More on this below). COVID forces that modification, since it is clear that no one has any idea when the mortgage secondary markets will return to “normal” and everyone with eyes can see that buyer behavior will change for good. Now that could be temporary, since it is clear (to me at least) that the real opportunity with iBuying is in mortgages, but in this, the ball is not in Zillow’s court.
We will have to wait and see what happens to the global mortgage market.
Gasoline, Meet Fire
In my COVID-19 and Real Estate Special Report, I concluded that iBuying will return with a vengeance once the crisis is done.
Second, and more long-term, the psychological impact of COVID will not entirely fade away until and unless a simple, over-the-counter cure being not only introduced, but proven.
The selling process was already inconvenient, uncertain and time-consuming.
If the seller has to worry about strangers walking into his house and whether they are infectious, and the showing process now has to involve booties, masks, disinfectants, and the like… the incentive to simply sell to an iBuyer increases significantly.
We believe that the iBuyer model, so misunderstood and so maligned, is about to become far more mainstream in the aftermath of this crisis. What no one knows is the depth of the negative impact and duration. Depending on the market, you will get wildly varying answers. We believe we should see consensus emerge over the next couple of months, especially as we enter May and June
After that, in various posts, presentations, and podcasts, I theorized that even buyers psychology would be affected because of The Bug. Vacant homes, I thought, became far more valuable.
Well, here’s Barton in the earnings call:
Another great example of how this is unfolding before our eyes is our recent Zillow Offers customers Estevan and Stacy Garza who shopped for 2 years before they found their dream home at Zillow Offers owned home outside of Phoenix last month. The timing intersected with stay-at-home orders and social distancing requirements and the Garzas said that sale would not have happened without the flexibility and piece of mind that came with buying a non-owner occupied home from Zillow, which allowed the inspector and appraiser to easily do their jobs. Now, Estevan said they can take a deep breath and enjoy their beautiful new home.
The virtual tools home shoppers need for safety today, will become their expectations for convenience tomorrow. Our focus now is not just on managing our way through this crisis we are also moving faster to the future. Our vision of Zillow 2.0 is becoming a reality even sooner than we have had planned.
Like we discussed with you during our pop-up successfully navigating storms requires the ability to know when to pullback and tap the breaks and when to hit the accelerator. We are beginning to see our passing lane.
Make no mistake we are clear-eyed about the public health and economic crisis on the ground and are doing what’s right to actively support our employees, partners and communities and we are mindful of how important it is for the company to have extra buffer for the uncertain future, but we are also not blind to the opportunities being unlocked to accelerate a new era for real estate.
We are not alone in this endeavor. We are leaning in to lead, working closely with our partners and industry leaders to move the entire category forward and ensure that no matter what happens in our world we can assure our customers that real estate is always on to help them move safely into life’s next chapter. We are ready. Our customers are ready. Time is now. [Emphasis added]
COVID accelerated trends; Barton confirmed that at least one company is going to step on the gas (even though the accelerator was already pinned to the floor… so maybe it’s more like nitrous oxide injection coming next?).
What might that be?
The Transformation of Real Estate
In the Q4 analysis, I wrote that the transformation of Zillow is complete. Now, I think COVID is presenting Zillow with the opportunity to transform the entire real estate industry as we know it.
Here’s Barton during the Q&A, with John Campbell (a friend of NROB):
But from a competitive advantage perspective, I really feel like this situation has enhanced our competitive position.
We have the biggest brand and the biggest audience. And in these kinds of times, people tend to fallback on familiar and trusted and big brands. I think you are seeing that across industries right now.
We have a really strong balance sheet, the strongest balance sheet in the industry which is also terrific to have in a situation like now.
We have the best partners. We have the best products intact. We have the best services and all of these things make me feel good.
Even the most devoted Zillow hater cannot deny any of the above. They fear Zillow and fear leads to hatred, but biggest brand, biggest audience, strongest balance sheet, etc. etc. and so on are unarguable.
What follows, however, is and will be argued vociferously by those who pick up on the message:
Turning to the partner side, there are probably fewer choices on how to market themselves and how to generate customer demand, how to generate relationships and generate commissions. And so we may be finding that they are focusing their marketing energies on Zillow and Zillow Group’s brands.
Oh my. Those of you who are from the industry will have an immediate emotional reaction to this statement. “It’s all about relationships!” has been drummed into every single real estate practitioner for decades that it is something like a religious mantra.
All I can advise is, now might be a good time to keep as open a mind as you possibly can.
We are also advantaged, because we are seeing like in so many industries that you guys are looking at you are seeing really – you are seeing years of technology progress get accelerated down to a month. And as the leaders – as the tech leaders in this industry, we are in a position to lead and we are the beneficiaries of that.
As I said in my script, I said something like today’s necessity for this kind of distance shopping and buying is tomorrow’s expectations, because of course, virtual buying rich media experiences, 3D floor plans, virtual touring, electronic trafficking of documents and signing of documents that’s all exactly what people what people’s expectations for a 2020 industry [and] how it should operate.
But today’s real estate industry has not been operating that way. It’s been operating as if it’s back in the 1960’s or 1970’s.
Anyway because of all that we’re in a really fantastic position to accelerate out of this period of uncertainty, and as we’ve said we’re seeing a lot of green signals. Lights that were red only two months ago are moving through yellow and beginning to flash green, and so we’re not out of the woods yet but we’re moving with a lot more confidence.
Those who are long-time VIP will remember the Q4 analysis, when I talked about the Conversion Challenge, and Rich Barton talking about Zillow’s upside in solving the conversion problem.
It’s worth repeating, although long:
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.
And I do think it would be worth your time to go back and re-read this part of the Q4 analysis.
Putting two and two together, what I get is this:
- Zillow has already been working on the conversion problem.
- They have already been working on mechanizing and professionalizing and applying technology to the sales and nurture funnels.
- COVID comes along and wipes out some of the barriers to technological progress.
- Some of Zillow’s best partners (i.e., agents) are becoming more dependent on Zillow, because there are fewer choices for the old ways to generate relationships and commissions.
- Brokerages, which had never truly invested in technology, are still operating as if it’s the 60s or 70s. COVID smashes that.
- Green lights are flashing.
- Zillow is fully aware of how today’s needs become tomorrow’s expectations, and have the money, the engineering talent, and the will to do something about that. The rest of the industry lacks at least one or more of those three things.
What do you think happens next?
Not Going Back
I’ll reserve my own thoughts for a future publication, as this is getting super long even by my standards. But I will leave you with what Rich Barton thinks happens next:
This is not going – we are not going to bounce back to the way things were done before.
We are seeing all kinds of systems, processes, business models, players change right now.
And there are going to be a bunch of sad stories there, but there are going to be a bunch of happy progress for our consumers and for the industry as a result.
A lot of the technology that I have already been talking about, this kind of Real Estate 2.0, a modern platform for virtual shopping and digital closing. That’s all – it’s just – it’s really rapidly progressing right now and that’s not going to go back either.
Zillow 2.0 is reality. What comes next is Real Estate 2.0
I know I’ve been talking about that for years. The difference now is that I’m not the one saying it; Rich Barton is. And he has just a tad more capability than yours truly does to make predictions come true.
Zillow is not going back. None of us are. Not because we don’t want to, but because we can’t. Events have passed us by, and the world has moved on. The question that remains is how we are gonna make each moment better than the last? How are we gonna make it better, if we can’t go back?