Zillow, 2Q/2021: Investors Just Don’t Understand

In a few years, we’ll look back on 2Q/2021 and think that it was an important turning point for Zillow and the industry. Or it might be yet another step forward in the slow march towards the transformation of housing into e-commerce. But either way, looking at 2Q/2021 performance and the investor’s reaction to it, I think it is becoming clear that most of Wall Street simply doesn’t understand what’s going on. Let’s see if we can point you in the right direction.

As I’ve written before, if you need background on my thinking on Zillow, please go back and re-read everything I’ve written about Zillow after every one of Zillow’s earnings calls. Then you can check out my June 2018 Red Dot on Redfin, Zillow, Realogy as well as various other Red Dot reports including the September 2018 issue Game of Platforms.

A Few Numbers

Since the game is to manage expectations, Zillow blew through those:

• Consolidated second-quarter revenue of $1.3 billion and revenue for the IMT and Homes segments exceeded the high end of the company’s second-quarter outlook.
• Consolidated second-quarter gross profit was $538 million, up 92% year over year.
• Consolidated net income was $10 million for the second quarter. Segment income (loss) before income taxes was $134 million, $(59) million and $(18) million for the IMT, Homes and Mortgages segments, respectively, for the second quarter.
• Second-quarter Adjusted EBITDA of $183 million and Adjusted EBITDA for the IMT and Homes segments exceeded the high end of the company’s second-quarter outlook. Adjusted EBITDA by segment was $218 million, $(29) million and $(6) million for the IMT, Homes and Mortgages segments, respectively, for the second quarter.
• Traffic to Zillow Group’s mobile apps and websites in the second quarter reached 229 million average monthly unique users, an increase of 5% year over year, driving 2.8 billion visits during the quarter, up 10% year over year.
• The company ended the second quarter of 2021 with cash and investments of $4.6 billion.

On the whole, Zillow kicked ass. We know this, and most of us expected it.

Of course, we have these numbers for the all-important Zillow Homes division, which is what anchors the future of Zillow:

Last quarter, I wrote that Zillow was proving that the hot housing market did not change the fact that consumers want speed, certainty and convenience. This quarter drives the point home, with Zillow buying 3,805 properties while selling 2,086.

The reason I posted the numbers above, with my add-ons, is to look at the costs as a percentage of revenue. I got curious about Zillow’s operational efficiency improvements over time, especially on the selling costs side after ZG brought that work in-house to its new brokerage division.

As you can see, on a YOY basis, Renovation costs are down 46%, Holding costs are down 56%, and Selling costs are down 11%, all on a percentage of revenue basis. While the speed of the sales and the price appreciation during the holding period all play a part, one has to imagine that there is something going on behind the scenes in terms of automation and process improvement.

The upshot is that Zillow’s iBuying business is generating almost $20K per home in after-interest returns, at 5.31% versus a year ago when it was losing $7K per home, a -2.2% negative return.

So all of this is very positive. Yet, as of right now, ZG is trading at below $100 per share down from a 52-week high of $212 per share. Since the earnings release on the 5th, the stock is down about 10%. What gives?

I spoke to a few friends and contacts who are in the finance business and have a theory: investors just don’t understand the new Zillow 2.0

Wall Street Thesis on Zillow

First, I think most investors think of Zillow in one of two ways. They think that it is either an advertising portal making money from agent advertising, or a flipper using lots of cash.

The Zillow bears tend to think Zillow is an advertising portal who has gone badly astray into iBuying, from a high-margin tech business to a low-margin home buying and selling business so want to knock it down for that reason. Or, the other kind of bear thinks that even if Zillow is really an iBuyer now, it’s not showing the kind of growth and improvement and profit margins that they want to see. Zillow is vastly overvalued on that kind of analysis, and so the stock price is getting punished.

The Zillow bulls tend to think that Zillow is an exciting market maker who will soon transform the way we all buy and sell houses. What they’re looking for is continued margin improvements through better pricing, better and more automated renovations and selling processes, and cutting down on various costs. As yet, they haven’t really seen that take off yet, so while they believe in Zillow as an iBuyer, they just don’t think Zillow has proven that they can execute.

Both the bears and the bulls, however, think that the American housing market is in a near-bubble and can’t possibly sustain the kinds of double-digit YOY growth in prices. There’s a lot of evidence out there suggesting that perhaps consumers are pulling back from buying houses right now, both out of fiscal caution and out of sheer frustration. Stories of homebuyers putting in a dozen bids and losing every single one are all over the media.

So maybe Zillow will ultimately become a great category-transformation story like Facebook or Apple or Netflix or Tesla. But they’re waiting to see how the housing market and Zillow’s own execution shake out.

Both the bulls and the bears are wrong.

The Truth About Zillow 2.0 and Why 2Q Was Significant

I already wrote this after the 1Q report (and dozens of times before that) but what both the bulls and the bears are missing, I think, is that Zillow Homes is not about homes; it’s about mortgages.

Let me paint a (brief) picture, since I have been insisting on this since 2014 or so when Opendoor um… opened its doors.

In 1Q, I quoted Rich Barton saying that they don’t want to make margins on buying and selling homes. They want to make iBuying “go mainstream” and become far more commonplace:

But what we’re aiming to do is to provide a fair offer and charge a fair fee to our customers. And thus we believe we maximize the TAM, we maximize the number of transactions we can touch and participate in. And we have the ability to sell a bunch of adjacent services around those transactions.

In 2Q, we get this:

But ultimately what we’re trying to do is get people an amount of dollars in their pocket that they would have gotten approximately what they would have gotten via any other way that they would have sold, that’s the goal. And we think doing that, offering a fair price, it’s a terrific consumer proposition and a great business for us.

Go back and re-read my 1Q report for more on this motivation.

Now, longtime readers know that I’ve been saying since 2016 that from the very beginning, iBuying has been about mortgages. In 2019, I explained my theory on what I think Zillow’s ultimate long game is in this post. Let me summarize that theory briefly:

• Zillow, like other iBuyers, want to capture some percentage of the $1,744 trillion mortgage market. There’s a lot more money there than in the $60 billion or so in real estate commissions.
• The way to do that is to offer seller-financing of owned homes in inventory.
• At some point, these iBuyers will package up these mortgage notes into an MBS and sell it directly to investors who currently invest in RMBS.

In other words, the iBuyers are not interested in cutting out the middleman that is the real estate agent, except to the extent that these agents increase friction in the transaction. They’re interested in cutting out the middleman that is the global financial system which allows Norwegian pension fund money to end up financing the purchase of a family’s home in Atlanta.

So it was significant to me that Zillow went and acquired not a mortgage broker, but a mortgage bank, and then staffed it with people with deep experience in Non-QM lending.

Now, two pieces of news dropped in 2Q of 2021 that are important. I can’t decide if these two pieces are turning points, or just a step forward yet.

“Quantum Gross Profit”

The first piece of news is around what Rich Barton called “quantum gross profit,” a term that does not exist, leading one of the analysts to ask what that means.

This came from a seemingly small announcement about accounting changes, where Zillow would really focus on gross profit as a metric of success. But Rich Barton made a point of talking about this in his prepared remarks:

Moving forward, we plan to focus on growth profit dollar growth as a key measure of success. First and foremost, the metric is increasingly how we are measuring the business internally. Instead of optimizing for gross profit dollars generated by one particular service, we are increasingly finding ourselves thinking about the total enterprise gross profit pool that is produced when we offer multiple services to our customers. We think this creates the right incentives to run our business and as much more in line with how we want our end customers to think about what we offer to them. [Emphasis added[

Later Barton called this “quantum gross profit” (he likely meant something more like “combined gross profit” across the entire enterprise). He then explained his thinking behind this “accounting” change:

We also want to be able to play with pricing as well without having internal competition. It’s all just one transaction.

This is not a small accounting change; this is an announcement of a new(?) operating philosophy for Zillow Group.

Frankly, there are only two real threats to Zillow Group today: government regulation (more on that in future posts) and internal politics. As Zillow is no longer a young ambitious startup but a major publicly-traded company, the executives in charge of the various business units will naturally turn their eyes more and more inward at each other. This is a well-known phenomenon across all large businesses, as the personal reward for getting promoted (i.e., beating internal competition) far outweighs the reward for beating external competitors.

Except that way lies death for Zillow. If Arik Prawer over Zillow Homes is competing with Susan Daimler over Premier Agent who is competing with Jeremy Wacksman who is competing with somebody else, then Zillow will never be able to actually monetize the iBuying platform via the longterm mortgage play. That longterm vision requires cooperation and collaboration across disparate business units whose leaders have a natural incentive to do engage in turf wars, internal politics and one-upmanship games.

So I think this announcement is not a small one; I think it is a major one that lets careful watchers (and there is no one more careful than yours truly on this topic) get a glimpse behind the curtains. I suspect that there have been senior strategy meetings and such where Rich and Lloyd and Allen Parker laid down the law on the senior managers on the new “sharing is caring” modus operandi. Time will tell whether they were successful or not.

And in that context, the focus on “ancillary revenues” such as Mortgage and Zillow Closing Services is appropriate. Those are not “ancillary” in any real sense of the word; they are the actual core profit engine, with both Premier Agent and Zillow Offers and rentals playing more of an integrated top-of-funnel type of approach.

Rich says as much, because he is remarkably transparent (almost naively so) in his quarterly calls:

Okay. So yes, I mean, clearly Zillow is going – going – accelerating as you noted. And you also noted that kind of interestingly, so is everything else, all right. And it’s not just the market that’s doing that for us. PA is cooking really nicely and has plenty of room, our Premier Agent business. Rentals is growing nicely. Mortgages is going and Zillow Closing Services is going really nicely as well. It just turns out it’s not a surprise. It’s a bet we’ve made. But it just turns out that all of these businesses are interrelated because it really is. They’re all just part of one transaction. I’ve come to think of them as different doors into the same room. That room is I want to move, make it easier, please, so our ability to increasingly package integrate and offer these mix and match menu of services is clearly working. The numbers tell the story there.

So that anecdotal data point we gave you, you just cited the 40% of purchase mortgages originating with Zillow door is one of the kind of specifics we’re sharing to kind of give some light on that. We also have had some early success with our Zillow 360, which is a new package that offers a discount that we’re playing around with. And that’s showing real promise. The Zillow Closing Services attached is going well.

This kind of approach also happens to be the profit engine that Compass, EXPI, Redfin, and every other company in real estate wants to build. But only Zillow and Opendoor and to a far more limited extent Redfin have the ability to do the seller-financing piece that is critical to the longterm play in mortgage.

Speaking of which…

Zillow’s MBS

I nearly fell off my chair with excitement when Rich Barton said, “Additionally, earlier this week, a Zillow Offers subsidiary launched and priced a securitized debt offering, which is expected to close next week.”

Then Parker expanded on the offering:

Earlier this week, at Zillow Offers subsidiary launched in price its securitized debt offering, which is expected to close on around August 11. The company anticipates gross proceeds of approximately $450 million from the offering. The securities will have a 30-month term and a 24-month reinvestment period in a weighted average interest rate of 2.43%, which is lower than the rate on our existing credit facilities. Similar to our existing debt financing, this is a non-recourse to Zillow group subject to limited exceptions. Proceeds of the offering will be used to finance the growth of Zillow Offers business. The securities weren’t registered and nothing on this call should be interpreted as an offer of the securities.

This isn’t the Big Move I’ve been waiting for, which is for an iBuyer (likely Zillow, but maybe Opendoor) to take all of its seller-financed mortgages, package them up, and offer white-label RMBS for sale in the marketplace. This isn’t that kind of a MBS, from what I understand.

Yahoo Finance has more detail:

Zillow Group Inc., the online real estate giant, is borrowing $450 million through mortgage bonds backed by collateral from the company’s nascent home-flipping business.

Zillow initially planned to borrow $300 million, but upsized the offering due to investor interest, according to people familiar with the effort. The company can recycle capital from the offering for up to two years as it buys and sells homes, said one of the people, who asked not to be named because the matter is private.

This MBS is more of a short-term borrowing facility to let Zillow buy more homes at lower cost. That’s smart, but it isn’t the kind of thing I imagined when I wrote my long game post.

But you know what this is? It’s a big step forward for Zillow’s people and their financial advisors to do a mortgage-backed security at all. And it wasn’t tiny: $450 million is not tiny. They will have learned a great deal from trying to package and sell Zillow RMBS in the first place.

Perhaps the next one, or the one after that, will be the Big One that I’ve been waiting to see for five years.

What the Bears Get Wrong

With that as background, I think the Zillow bears get the entire company wrong. Zillow is no longer a portal dabbling in a funky iBuying business; it is a market maker that happens to operate the largest real estate portal in America. This is a permanent shift.

And for those bears who thinks that even if they do agree that Zillow is really an iBuyer, it’s just not growing fast enough, especially against Opendoor, and therefore its stock price is vastly overvalued… well… I’m not an investment analyst, so have no opinions on whether Zillow stock is or is not overvalued.

What I can say is that any hope of Zillow Homes having some kind of breakthrough in terms of profitability needs to be laid to rest. It is never going to happen. Rich Barton has more or less told you as much over and over again. The +/- 200bps guardrails are just that: Zillow doesn’t want to make more than that from its iBuying activities, because they want to pay a fair price that makes this way of buying and selling houses the new norm in much the same way that Elon Musk wants EVs to be the new norm with gas-powered cars being reserved for rare sports cars and classic muscle cars or the like.

However, being bearish on that basis alone is incorrect, because….

What the Bulls Get Wrong

The Zillow bulls agree with the bears that Zillow wants to be a market maker, except that they think Zillow will eventually/soon breakthrough and make market making the new normal. And when Zillow does that, they will start to mint money the way Netflix and Google are.

This is also wrong, because Rich Barton has no interest in making money from Zillow Homes. He has every interest in making money from the company as a whole, through mortgage, title, escrow, seller lead generation, Premier Agent, etc. etc. and what have you, but I think even the bulls should take Barton at his word when he says he doesn’t want to make too much money from Zillow Offers.

Instead, I think the bulls need to think hard about the “quantum gross profit” thing and what Zillow is trying to tell you with that change.

The Proper Understanding

Let’s wrap up what is already too long a post with what I think is the proper understanding of Zillow 2.0.

Rich Barton did not come back to be CEO in order to make a few bucks. He was already a billionaire with an unbelievable life; why in the world would a man like that want the headache of managing a major public company in residential real estate, a job that carries with it the need to put up with abuse from traditional brokerages and MLSs and REALTOR Associations?

As I have written on this blog before, I believe Rich Barton came back because he saw the opportunity to propel himself into rarified air inhabited by names like Jeff Bezos, Mark Zuckerberg, Reed Hastings and Elon Musk and Bill Gates and Henry Ford. These are men who have fundamentally changed the world and have had historical impact.

Barton wants to change the way homes are bought and sold. The only way to really do that is to change how homes are financed. iBuying has never been, is not today, and will not be about buying and selling homes. This isn’t a buy for a dollar, sell for two trading business. iBuying has always been, is today, and will in the future be seen clearly as being about buying and selling mortgages but in a way that reduces the pain and delay and inconvenience of the home transaction process.

Today, Zillow is behind Opendoor in that core market making activity. But it has the largest real estate portal in the country, and a near-zero CAC advantage that it will leverage. By moving towards the “quantum gross profit” model, Rich Barton wants to try and drive his very smart, very capable and very ambitious executives to cooperate and collaborate so that he can achieve his vision of changing the world.

Whether Zillow stock is or is not overvalued depends entirely on whether he can get his entire company rowing in the same direction. It depends entirely on whether he can challenge and change the way homes are financed, cutting out many of the middlemen in finance (rather than in real estate).

The real competition for Zillow (and by extension of this analysis, Opendoor) is not Compass and Redfin and Realtor.com. The real competition is Wells Fargo, United Wholesale Mortgage, Quicken Loans, Fairway Independent Mortgage and JP Morgan Chase.

And from that perspective, Zillow has taken a couple of big steps forward in 2Q of 2021. We’ll see in the years ahead how important those steps were.

-rsh

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