Zillow Q3/2020: Apex Predator

First, an apology: I meant to get this post up soon after the earnings call, but… um… I’ve been distracted by the goings on in our country. I’m sure I’m not the only one. But while that is the reason, it remains merely an excuse, and for that, I am sorry. Perhaps by the time you’re reading this, we’ll have an answer….

Going through the Q3 earnings results from Zillow, the song Steady, As She Goes from The Raconteurs popped into my head. It’s not really on-point as that song tends to be somewhat… skeptical, if you will, of said steadiness… but the refrain is catchy as hell. And that’s what stuck. Because Q3 seems like yet another step towards the high level trend I’ve been predicting for quite a while now. For anyone coming to Notorious VIP for the first time, let me just suggest that you use your membership and go back and read some of the archived member-only articles. If you want more, contact me for longer reports, some of which date from 2017-18.

Zillow blew the doors off in Q2, and Q3 was more of the same. We’re talking record profitability, revenues far beyond expectations, and the like. By now, we all know just how great a quarter Zillow had.

As Allen Parker, CFO, put it:

The inputs across our businesses accelerated more than expected. This, combined with our ongoing operational rigor, delivered results that exceeded our outlook for revenue and EBITDA on a consolidated basis and for each of our segments. We reported consolidated revenue of $657 million for Q3, exceeding the midpoint of our outlook by nearly $100 million. Consolidated Q3 EBITDA was $152 million, double our outlook of $70.5 million at the midpoint of our range.

Stronger revenue, combined with continued focus on managing costs, delivered consolidated EBITDA of $16 million, significantly outperforming our expectations of a loss of $61 million at the midpoint of our outlook range.

Yeah… they were expecting to lose $61 million and made $16 million instead. And that’s with iBuying just starting to come back, which would suppress profitability since Zillow — unlike say Redfin — didn’t furlough anybody, didn’t lay anybody off, and just kept paying salaries. The big “holy crap” number has to be this one:

IMT segment revenue of $415 million, grew 24% year-over-year as we saw acceleration in all of our IMT marketplaces. Our strong position, brand and planful approach enabled us to participate in the great reshuffling that we’re seeing, benefiting all of our marketplaces. IMT segment EBITDA was $195 million or 47% of segment revenue. IMT segment EBITDA grew 114% versus this time last year, which translates into more than $100 million of incremental EBITDA profit.

IMT profitability more than doubled. $100 million in additional profit. Just as a point of comparison, Redfin’s total gross profits in Q3 was $93 million. RE/MAX’s total adjusted EBITDA was $30 million. And the $195 million in segment EBITDA is 2/3 of the total Operating EBITDA of all of Realogy’s businesses.

Zillow posted $40 million in Net Income, and much wailing and gnashing of teeth were heard across real estate as the haters who had been harrumphing Zillow all these years because it has never made a profit realized things have changed.

Since we don’t do deep dives into the numbers themselves anymore — plenty of other sources for that — let’s turn to some of the between-the-lines takeaways. That’s why you come here anyhow, right?

Ecosystem Economics

If there was a theme to Q3, it’s “ecosystem economics.” The following are from the earnings call, and all are from Rich Barton, CEO. Any emphasis is added.

We’re building adjacent services in both mortgages and title and escrow and will continue to drive market share and ecosystem economics as we spread our low customer acquisition cost across all of these services. This is our Zillow 2.0 vision for the future of real estate. Seamless customer experiences across our products and services, which will deliver additional economic benefits to Zillow, capitalizing on the customer trust we’ve spent so many years cultivating.

and

I’ll just hammer that point these kind of — we’re pretty focused on these ecosystem economics. As we think about all of these adjacent opportunities, and we really see our kind of P&L and business advantage as translating this low customer acquisition cost that we have with this huge traffic base in this big brand that we’ve built over all these years, and being able to, A, do more transactions, convert to more transactions; and then B, add more other transactions to that transaction and maximize the number of spin-off transactions from all those. So it is a really — it’s just a — it’s a really interesting long-term opportunity that we see lots of blue ocean.

When Rich Barton says ecosystem economics, it sounds all sexy and techie, doesn’t it? Except that in the real estate industry, we have known about “ecosystem economics” for a couple of decades and have always called it “ancillary services.”

This is the big news. This is the battleground for the next few years. Every single one of you who have been following Notorious ROB for a while has seen this coming, because I’ve been talking about it, but let’s go ahead and spell it out now. It’s interesting to do it in the way that Rich Barton formulated it.

Do More Transactions

First, as Rich spells out, Zillow is now engaged in an optimization exercise of how to convert its huge traffic base into more transactions. I find the use of the word “convert” interesting since before Flex, that just wasn’t a concern of Zillow’s; it was a concern of Zillow’s Premier Agents.

Thing is, even before Flex, Zillow had long recognized that not converting traffic into transactions wasn’t just bad for its P&L, it was bad for the consumer experience. Despite what zHaters have said for years, very few people are going to a real estate website just to look at homes of celebrities; they’re going because they want to buy a house. So not buying a house is a subpar experience. Now, Zillow had been talking for years about how half of the inquiries to Zillow went unanswered, which sucks for the consumer, and sucks for Zillow’s brand. That’s one of the primary reasons why Zillow transitioned to Flex.

Truth is, if real estate agents had been better at responding to inquiries and providing services, Zillow might not have gone to Flex. Its advertisers (Premier Agents) may have been happy to keep paying up front for all the leads, which they would have followed up on, serviced, and converted into transactions. We know this because some of Zillow’s Premier Agents were pissed off when Zillow rolled out Premier Agent 4.0, the precursor to Flex, because they were doing a great job at following up and converting leads. Zillow went to Flex because far too many real estate agents suck at the basic task of responding to customers. How do we know that? Because that problem, of getting agents to do basic things like to respond to someone who might want to buy or sell a house, is one that brokerage managers and agent team leaders have even today.

The significant statement above — and it may have been subconscious on Rich Barton’s part — is how Zillow is taking responsibility for converting leads to transactions. Again, maybe this is just casual speaking during the Q&A, but it is “we” that have to do more transactions, convert to more transactions, not “our customers” or “our partners” that have to do more transactions, convert to more transactions.

We’ll return to this shortly.

Add More Other Transactions

Once Zillow decided that it has to take a hand in doing more transactions, then naturally, ancillary revenues will come to the forefront of anybody interested in making money in real estate.

I have long pointed out on these pages and elsewhere that for more real estate brokerages, the profits are in ancillary services like mortgage, title, escrow and insurance. It isn’t in brokerage. The average brokerage in North America does 3% in net profit, according to RealTrends; they stay in business because that loss-leader brokerage operation feeds the mortgage, title, escrow, and other ancillary businesses.

Our research in Q3, which was cut short by COVID (long story), suggested that while brokerages were sanguine about Zillow’s involvement in the lead generation game, and were willing to accept even Zillow’s morphing into a brokerage with a referral-based model, they are not all that ready or willing to give up ancillary services. One might even say that they can’t; it is literally where the money is.

Back when Compass was much on everybody’s mind, I theorized that they must have gone to investors and pitched a story about the agent-centered economy. The strategy, broadly, might have been: recruit agents, overpay if you must, so you can capture the ancillary revenue. I wasn’t just pulling shit out of thin air, since Reffkin was pretty open about it in 2018, as this The Real Deal story says. Reffkin was telling people that agents are “at the center of the referral economy.”

What he didn’t get into, since he was speaking to agents, was what the brokerage would earn from this referral economy. But it isn’t difficult to imagine.

Well, here’s Allen Parker in the Q3 earnings, responding to a question about Zillow Home Loans:

With respect to your second question, we view this as an opportunity to serve our customers regardless where they come in. So Zillow Offers is one, working with our Premier Agents and their customers is another as well as direct-to-consumer. We also have a marketplace business. So we think that there’s a lot of opportunity if we build a great product and an integrated transaction to make it seamless and less friction to continue to grow this business. We’re just in the very early stages. We’re really happy with the leadership team we brought in to build the originations business, and we’re in very early innings, but we see a lot of opportunity there.

Of course they do. Zillow Home Loans will have insanely high attach rates for ZO homes, because ZO homes are now sold by Zillow employees. But of course they’ll work with Zillow Premier Agents and their customers. The question is… at what attach rate? The industry is thrilled if they can get 10% attach rates on their in-house mortgage operations. What will Zillow get from its Premier Agent partners?

That Word Partner…

In this context, consider how Zillow has stopped referring to its agents as customers, but as partners. I’ve pointed out that this is a big change in the Zillow Q1/2019 writeup, almost two years ago now, but the change began in 2018. I cited my June Red Dot Report in that post linked above:

Throughout this transformation, perhaps nothing transforms more than the relationship between Zillow and the Premier Agent.

Today, the Premier Agent is an advertiser on Zillow. For a certain amount of money, Zillow promises a certain number of impressions (CPM-based pricing) of that Premier Agent.

Tomorrow, the Premier Agent becomes something far closer to the windows installer for HomeDepot. Sure, she is still an advertiser. She will still have a customer service rep at Zillow, and a salesperson at Zillow who will be trying to get her to spend more with Zillow.

But when Zillow holds the relationship with the actual buyer or seller, passing them on to her only after they have been “validated”, the relationship changes slightly… but in a profoundly important way.

Now Zillow becomes more like a source of revenue for the Premier Agent, in much the same way that a local windows installer regards HomeDepot as a source of revenue, not as an advertising platform.

Sure enough, Zillow started to refer to Premier Agents as “partners” not too long thereafter. And it has stuck with that formulation. The home buyer or the home seller is Zillow’s customer, and the agent is Zillow’s partner.

Now, I bring this up in the context of the ecosystem economics because… the word partner implies a two-way street. Sure, sure, companies use the term “partner” all the time to refer to people and other companies who are not at all partners, but despite the efforts of PR flacks everywhere, the word does still mean something.

The Q3 IMT results make it clear that Zillow’s Premier Agents love Zillow; we saw that in Q2 from interviewing many of them. Now, they don’t love Zillow for some idealistic reason, mind you, but because Zillow makes them money. My favorite quote from real estate social media, which I nominate for Straight Gangsta Quote of the Year, sort of captures the vibe perfectly:

Given that Zillow is making its Premier Agent partners a mountain of money, is it too farfetched to think that Zillow would appreciate its partners to maybe think about referring Zillow Home Loans or Zillow Closing Services to their buyer or seller clients?

And of course, the opposite could also be true: consistent failure to send any ecosystem business to Zillow could be seen as a sign that the partnership perhaps isn’t as strong as it could be, as it should be. That might encourage Zillow to look for better partners in that local market, agents who might appreciate the opportunities that the partnership brings to them and is willing to reciprocate to make sure that their partner is succeeding as well.

I realize this is pure speculation on my part since none of Zillow’s people have ever suggested anything like this in any public statement anywhere at any time. But human nature being what it is, I can’t help but wonder.

And yes, I know about RESPA. But I also know that mortgage and title reps talk on and on about their close partnerships with real estate agents. And within the industry, we know that brokerages put pressure on their top agents, who have the best commission splits and all sorts of other goodies from the brokerage, to *cough cough* think about, you know, mentioning the in-house mortgage company and *cough cough* recommending the in-house escrow company. Just sayin’.

And right there, there is the next battleground between Zillow and brokerages. And everything will depend on who the top producing agent is loyal to. I am biased in how I see that playing out, because I think 90% of business lessons can be learned from The Godfather and The Godfather II.

I don’t know about you, but I think I know who Charlie Onumonu will be loyal to when push comes to shove.

Understanding the We

I said we would revisit the issue of how Rich Barton said “we” have to do more transactions, convert the traffic and leads to more transactions. Yes, it might just be reading too much into a casual back and forth, but I think it’s more interesting to think it was a Freudian slip. Why?

Because we can connect that statement right back to one of the most interesting things Barton has said in the Q4/2019 earnings call: Zillow developing agent technology that tackles the problem of conversion. I wrote about that here, and quoted Rich Barton from that call:

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.

I said then that this is the next piece of the puzzle for Zillow’s domination of the residential real estate industry.

I think weaving the various strands throughout the years together gets us to the narrative that makes the most sense. Remember how I said that if real estates agents had been better at responding to inquiries and providing services, Zillow might not have gone to Flex at all? And that the problem of getting agents to do basic things like to respond to someone who might want to buy or sell a house is one that brokerage managers and agent team leaders have even today?

So here’s Zillow, who wants to provide a better consumer experience to the millions of people visiting its websites every day, who felt they had to go to Flex with all that involved, like consumer surveys, CSAT scores, Best of Zillow, and so on. They are focused on the high performing top producing agents who can deliver that great customer experience. Most of those agents, if not all of them by now, own and operate teams. Because once Zillow goes down the funnel a step or two, they have to care a great deal more about scale. A Premier Agent that can handle 10 customers a year wonderfully is great, but that doesn’t solve Zillow’s problem fully; they need scale, which means teams.

Those team owners can do a lot in terms of driving accountability on their team members. But they need systems and tools to help them do that, and to get the agents on their teams to do the basic things to convert a lead into a transaction.

That is precisely the technology that Zillow is developing, and according to Rich Barton in the Q2 earnings call, that is the top development platform priority, geared towards consumer experience. And that is the technology that Zillow will make available one day (soon?) to its Premier Agent partners.

I think that’s the correct way to understand the “we” in Rich Barton’s statement. He is literally including the Premier Agent partners in the “we” which is a fairly powerful statement if you think about it. It implies a unity at least in Barton’s mind between Zillow and its Premier Agent partners, hence “we” have to do more transactions.

If that sentiment is returned by the Premier Agents, then the ecosystem economic battle is over before it began.

A Note on Zillow Homes

I don’t actually think there’s a whole lot to say about the iBuying practice at Zillow. Q3 wasn’t great, but that has a lot to do with the fact that Zillow took a pause in Q2, like everybody else. They’re back to work full force, but it’s going to take time to build up inventory to sell. So I’m just not entirely too sure how much to read into Q3 results, which were not great. Per-home revenues were down, costs were up, and margins were bad. But it seems silly to make too much of that given the disruptions from COVID.

Barton did speak about how consumer awareness of Zillow Offers remains very low, and that it will take time. The market share certainly isn’t mind blowing or anything (which bodes ill for my bet with my friends about iBuyer market share by 2024… but I digress).

The Market Headwinds

I’ll add an observation here, because I’m certain some of you (particularly investors) will wonder about it. Fact is that Q3 was the hottest seller’s market we have seen in quite some time. There is no indication that the hot seller’s market is slowing down, with days on market and available inventory being at record lows across the country. Doesn’t that create a problem for iBuyers?

The short answer is, of course it does. If you can list your home and sell it with multiple offers in 48 hours, the value of certainty that market makers provide drops. It isn’t zero, despite what haters say, since a regular family buyer might not qualify for the mortgage, or the appraisal might not come in high enough, or a thousand other problems develop after the contract is signed. But I don’t think it is particularly questionable that “sell in 48 hours to a market maker” is less appealing when you can sell in 48 hours to a retail buyer.

The longer answer, however, is that a hot seller’s market reduces the value of certainty, but it does not impact the value of convenience and flexibility that market maker models bring all that much. The traditional list-and-sell still requires cleaning, repairs, staging, showings, putting the kids and dogs into the minivan, etc. etc. It still requires moving out by a certain date so the new owners can take possession, and maybe that date works for you and maybe it doesn’t.

Think of it slightly differently. If the cost of listing and selling were the same as market making, and the price you would get is the same from both, would anybody actually list and sell traditionally? The only argument that the haters make is that sellers leave tens of thousands of dollars on the table with market makers… and the data is very weak on supporting that proposition.

So I do think that Zillow has a major education campaign challenge on its hands, as I’ve pointed out in the past, but… that’s what you need to do if you’re introducing something brand new to consumers that is different from how they’ve done things in the past. See, e.g., Uber, Tesla, remote working….

Zillow the Brokerage

This wasn’t really mentioned, except in passing as Rich Barton saying that the move to bring ZO business in-house was just to streamline the consumer experience, and Wall Street analysts are not all that interested in digging into the details of how that affects things behind the scenes.

The real impact of the move, and I think one important reason why Zillow made the move, is that it defangs the brokerages against whom Zillow might have to go to war because of ecosystem economics.

Consider:

• Zillow knows that ecosystem economics is a blue ocean opportunity for cash money.
• Zillow knows that mortgages, title, and escrow are where the profits are made, and they plan to capture some or most of that.
• Zillow knows that the war that would break out between them and the brokerage community would make the war over syndication look like a lover’s quarrel.
• Zillow knows that the single biggest weapon that brokerages have against them is to cut off listings data.

Taking ZO business in-house was likely motivated primarily by consumer experience considerations, but it can’t have escaped brilliant operators who really know the industry like Errol Samuelson that the move would also defang the brokerages and take away their greatest weapon. Now, Zillow is a Participant Brokerage in all the MLSs where it wants to be, and a REALTOR to boot. Other brokerages cannot cut off the data to a fellow brokerage Participant without immediately and instantly drawing the attention of various antitrust enforcement authorities, or without wrecking the MLS system entirely.

When the fight comes, it won’t be over access to data. That issue has now been put to bed.

The fight to come will be for the hearts and minds of real estate agents, especially the ones who do the bulk of the transactions because they’re not incompetents who don’t return inquiries from consumers. Question is, who will they be loyal to? Their partner Zillow, who is sending them millions of dollars in commissions and is developing best-in-class software for them, or their broker, who takes big chunks of their income and buys them off-the-shelf software they could buy themselves… but makes them feel all kinds of important?

Of course things won’t be that simple or that cut and dry. NAR will surely look at doing something, and the brokerages are not going to simply lay down and go away. They’ll do something. Those things may or may not be anticompetitive; it’s impossible to say. But I can’t wait to see what they’ll try.

I will say this, though, because it will come up when we discuss some of the other publicly traded companies: if that something is building technology… good luck. Not one of them has the technology talent or the budget to contend with Zillow, whose top development priority is the “gnarly problem” of applying software and modern technology to converting a lead into a transaction.

Apex Predator

In conclusion, then, what Q3 tells us is that Zillow is all about ecosystem economics. You’ve been reading me long enough to know that was inevitable; it was the whole basis for the market maker business model, after all. But the extraordinary quarter that Zillow had, the confidence that Rich Barton and team have, and (as you will see) the performance of other players in the industry tell me that Zillow is the apex predator of the real estate ecosystem. They have the audience, they have the money, they have the resources, they have the technology, they have a distributed “workforce” in the form of partners, they have multiple business models and business lines, and they are building out the ancillary services to complete the ecosystem economics of real estate.

To be sure, there is another apex predator out there in the jungle. The new Opendoor is not to be taken lightly, but they didn’t report anything so we’ll have to wait and see how much of what they promised in their S-4 is bearing out in 2020 and beyond.

As of today, however, war is coming to the residential real estate industry as Zillow rolls out its plans for the ecosystem and it is difficult to imagine who among the existing players can take them on. In the meantime, Zillow keeps rolling on, steady, as she goes.

-rsh