Zillow Q3/2021: Riddle Wrapped in a Mystery Inside an Enigma

I was in mid-air when the Zillow Q3 earnings release happened. By the time I had landed, there were dozens of texts, emails, and of course, social media postings. There were and are a lot of hot takes.

I’m reasonably convinced that all or most are wrong in some significant way. Many are laughably shallow.

My initial hot take was and is likely wrong in some way as well.

So this isn’t a normal quarterly earnings analysis, because… frankly, I don’t think anybody cares about the business as usual. This is more of a think-out-loud piece, and I write it without having heard the earnings call or having read the transcript. I think I will reserve a part 2, thinking about what this means, for after having done that.

This will be based on what was announced, the Shareholder Letter, and the numbers reported… as well as the few phone conversations I’ve had since landing at McCarran with various individuals in the industry who are in positions to know a thing or two.

Relevant Numbers, Very Briefly

Because they are relevant to our discussion, let’s look very briefly at some key numbers. From the Press Release:

  • Consolidated Q3 revenue of $1.7 billion.
    • IMT segment revenue growth of 16% year over year to $480 million, and Premier Agent revenue growth of 20% year over year to $359 million, both within the company’s Q3 outlook ranges.
    • Homes segment revenue of $1.2 billion, below the company’s Q3 outlook of $1.45 billion at the midpoint of the range, due primarily to renovation and resale capacity constraints.
    • Mortgages segment revenue growth of 30% year over year to $70 million, exceeding the high end of the company’s outlook range.
  • Consolidated GAAP net loss of $328 million in Q3. Segment income (loss) before income taxes of $130 million, $(422) million and $(6) million for the IMT, Homes and Mortgages segments, respectively.
  • Consolidated Adjusted EBITDA loss of $169 million with Adjusted EBITDA for the IMT and Mortgages segments exceeding the high end of the company’s Q3 outlook. Adjusted EBITDA by segment of $207 million, $(381) million and $5 million for the IMT, Homes and Mortgages segments, respectively.
  • The company ended the third quarter with cash and investments of $3.2 billion.

Now, because it’s so important, let’s look at the unit economics from the Supplemental Financial Tables, with my little analysis included:

I know it’s a big long table, but I think it’s relevant for thinking through this.

The Big Surprise Announcement

Since the “pause” was just two weeks ago… the shocking announcement today was that Zillow was shutting down its Zillow Offers business entirely.

From the Shareholder Letter:

Today we announced financial results for the third quarter and, most notably, our decision to wind down our Zillow Offers operations, which will unfortunately involve a reduction in our workforce of approximately 25% over the next few quarters. This decision was not taken lightly, especially considering the hard work and commitment from the Zillow Offers team. Ultimately, we determined that further scaling up Zillow Offers is too risky, too volatile to our earnings and operations, provides too little opportunity for return on equity, and serves too narrow a portion of our customers.

It is difficult to express how much this news shocked me.

I think anyone who has read my work over the past few years knows that I am just about the biggest iBuyer bull there is. I’ve made that very clear. In the last post I had just put up, briefly discussing my take on Zillow’s pausing iBuying activity, I had simply handwaved away the hiccup:

My take from the start is that this is a tempest in a teapot, driven primarily by anti-Zillow sentiment on the one hand, and anti-iBuying sentiment on the other.

The whole “ZOMG! Zillow is losing millions!!!” thing that has brokers, agents, and their influencers dancing for joy is… well… misplaced.

Well, I will in fact eat this here helping of crow with fava beans and wash it down with a nice glass of chianti. As I often say here and in person, I don’t mind being wrong, and my strongly held opinions are subject to change based on the facts.

These are new facts.

Having said that, more I think about this, and more I look at the information available, less this decision makes sense to me. There are at least three giant gaping holes in Zillow’s narrative, and there are a number of smaller inconsistencies around those three giant gaping holes.

Giant Gaping Hole #1: Loss, Volatility, Risk

Yes, Zillow Homes had a terrible Q3. There’s no arguing that. We knew that two weeks ago when Zillow announced a pause in its purchasing. Somebody over there made a terrible mistake, or a series of bad mistakes. After the earnings releases, we now know that Zillow had to write down $304 million in the value of the homes in inventory, which led to the oversized loss at the Homes Division.

If this had happened at some other company, like at Redfin who had $764 million in cash and equivalents at the end of Q2, or at Realogy with its $701 million, I could see why the immediate decision would be, “Party’s over! We out!”

But this happened at Zillow, who had $4.6 billion in cash at the end of Q2. I said as much in my now-crow-eating post. $300 million is a lot of money, no doubt, but… it’s less than 10% of Zillow’s cash position. That’s a bit like a family with $10K in its checking account finding out that their son getting into a fender bender would cost them $1,000 in repairs.

It sucks, yes, but… hardly the end of the world. That doesn’t seem like a good enough reason to be like, “That’s it! No more cars for us! Burn the car down!”

So it can’t be about the money lost, could it?

Is it about the volatility and the risk/reward that Rich Barton and the folks at Zillow found unacceptable after a quarter like Q3?

From the Shareholder Letter:

In our short tenure operating Zillow Offers, we have experienced a series of extraordinary events: a global pandemic, a temporary freezing of the housing market, and then a supply-demand imbalance that led to a rise in home prices at an unprecedented rate. We have been unable to accurately forecast future home prices at different times in both directions by much more than we modeled as possible, with Zillow Offers unit economics swinging approximately 1,200 basis points from Q2 to an expected -500 to -700 basis points in Q4 2021.

Because of this price forecasting volatility, we have had to reconsider what the business might
look like at a larger size. We have offered sellers a fair market price from the start of Zillow Offers, while also being clear that the business would only become consistently profitable at scale. We have determined this large scale would require too much equity capital, create too much volatility in our earnings and balance sheet, and ultimately result in far lower return on equity than we imagined.

Global pandemic and a temporary freezing of the housing market, and then a supply-demand imbalance. Huh. When did that global pandemic start? And that whole temporary freezing of the housing market? That was… 2020?

Here was Barton on the Q2 Shareholder Letter, a mere three months ago:

Two and half years ago, we made a big bet to evolve from a search-and-find real estate marketplace to participate in the real estate transaction itself. Despite some monumental curveballs like a global pandemic, we are on track with each of the three-to five-year growth objectives we set for ourselves in early 2019. We are in a strong position and executing with operational rigor as we innovate and integrate our product offerings to deliver a seamless home transaction experience.

Not a whole lot of handwringing about pandemic and freezing and volatility a mere three months ago. Could it be because the volatility benefited Zillow Homes then?

Homes segment Adjusted EBITDA was a loss of $29 million, favorably exceeding the high end of our outlook range. The Adjusted EBITDA outperformance was primarily due to higher volume and operational improvements, as well as stronger than expected home price appreciation in our Zillow Offers markets. Average return on homes sold before interest expense was a gain of $21,335 per home, or 576 basis points as a percentage of revenue.

If volatility was the reason to get out of Offers business, then why not get out in Q2? That 576 bps is way way above the +/- 200 bps that Rich had set as “guardrails.” In the Q2 earnings call, he was positively delirious with optimism, despite the volatility:

I confess to being quite excited by how well Zillow Offers is doing in such a hot sellers market, which has me for one kind of probing at the perimeter of my kind of penetration and TAM expectations here. And thinking about, just how – we don’t know of course, but just how much of the market will end up moving towards iBuying and Zillow Offers solution, I don’t know, but comparatively more confident now than I was even a quarter ago – so even a quarter ago. So it feels good to me. TAM is a good question, but it is a question for later we’re so under penetrated right now at less than – way less than 1% of home transactions that we can kind of begin to explore that in more detail later, just because it’s such early days anyway.

Comparatively more confident now than even a quarter ago? We’re still under-penetrated? Way less than 1% of home transactions.

My, how things change… and with such… velocity. The emotions over there in Seattle seem as volatile as the modeling results.

In the Q3 earnings call, we get this:

Put simply, our observed error rate has been far more volatile than we ever expected possible and makes us look far more like a leveraged housing trader than the market maker we set out to be. We could blame this outsized volatility on exogenous black swan events, tweak our models based on what we’ve learned and press on. But based on our experience to-date, it would be naïve to assume unpredictable price forecasting and disruption events will not happen in the future.

If volatility and risk were the issue, wouldn’t the 576 bps from Q2 have triggered this line of inquiry three months ago? Shouldn’t we have heard deep concerns from the data scientists and algorithm experts that the models need serious re-examination if they couldn’t predict an upside of nearly 150%? Because a model that can’t see a 376bps upside probably can’t see a 376bps downside, right?

What makes this even more puzzling is that with whatever mistakes, with the write down, with supply chain disruptions, and whatever other excuse you want to throw in, Zillow’s own supplemental data shows the unit economics for Q3 (table above). Turns out, in a horrible Q3, Zillow made $7K per home as return after interest expense. Is that below expectations? Certainly. Did they lose $422 million in the Homes Division? Yes, yes they did.

But the unit economics for Q3 are 183bps, well within the +/- 200 bps guardrails. The buying and selling in Q3 returned $21.5 million in return after interest expense. That’s with whatever operational mistakes that were made.

Whatever. The larger point is that however big the loss, however volatile the market, Zillow had and has the war chest to deal with it.

They chose not to. They chose to close up shop instead.

I can’t understand that decision.

Giant Gaping Hole #2: Supply Chain Disruption and Scaling

Related to the risk and volatility thing is the whole operational challenge, supply chain disruption and the impossibility of scaling. From the earnings call:

We have also experienced significant capacity and demand planning challenges, exacerbated by an admittedly difficult labor and supply chain environment. The combination of these factors has caused a meaningful backup in our processing of homes in the Zillow pipeline, which we announced two weeks ago.

We judged future significant volume volatility to be a tough impediment to ramp a scaled operation, and any interruptions in the supply chain like we recently experienced will result in increased holding times, further increasing our exposure to volatility and lowering our return on equity.

Basically, the reasoning offered is that market making doesn’t work, except at scale. But scaling is too risky given labor and supply chain environment.

Trouble is, supply chain disruptions and labor shortages have been in the news since… oh, 2020? Certainly the summer of 2021 was one plagued with labor shortages. Here’s a Washington Post article from May of 2021 talking about the labor shortage. Here’s an article dated June 2, 2021 from NAHB titled, “Record Number of Builders Report Material Shortages.”

And yet, Zillow Homes had a record quarter in Q2. Somehow, knowing that there was a shortage in labor and supply for most of 2021, Zillow Homes didn’t ramp that shit up big time? And somehow, not having ramped that shit up big time, they posted a record profit in Q2.

Was scaling the operation up not an issue in Q2? The labor shortages and supply chain issues were already present. Why did we not hear much about that three months ago?

Well, Zillow made money in Q2; they lost money in Q3. That seems to be the only difference I can discern.

Finally, while not related to the labor and supply chain and scaling issues, I have to address this:

A final factor in the wind-down decision is that, to date, we have been able to convert only about 10% of the serious sellers who ask for a Zillow Offer, and have tended to disappoint the roughly 90% who didn’t sell to us. Given our hard-earned position at the top of the seller funnel with more than 220 million average monthly unique users and the popularity of the Zestimate, we believe there are better, broader, less risky, more brand-aligned ways of enabling all of our customers who want to move. [All emphasis added]

This makes even less sense. There was a time when Zillow entered iBuying, and Opendoor was still in its pre-pandemic pre-IPO phase, that many of us pointed out that a ginormous competitive advantage that Zillow had over Opendoor was that it could refer the 90% of the disappointed sellers to Premier Agents as seller leads.

My friend John Campbell of Stephens, Inc., one of the top analysts of this segment, wrote up a whole report on Zillow back in November of 2019 pointing out that modeling Zillow losing money on every single Zillow Offers transaction, but selling seller leads (45% of those disappointed sellers converting, and 10% of those actually closing, etc. etc.) and showed massive revenue bumps for Zillow as a result.

I’ve done such modeling myself, and others have as well.

Those seller leads are pure gold from a monetization and value standpoint, especially in a seller’s market like the one we’re in. But Zillow is cutting off the one program that generates high-intent seller leads because it is only able to convert 10% of the sellers? It just doesn’t add up for me.

Something is missing.

Giant Gaping Hole #3: Why Not Divest?

This ends up being the unanswered and unanswerable question.

Let’s assume that everything Rich Barton said in the Shareholder Letter and in the earnings call is true. Let’s set aside our skepticism and accept every bit of the narrative.

Zillow isn’t good at data modeling, programming algorithms, predictive analytics, whatever. Someone somewhere made a mistake. Zillow lost a huge amount of money, and they looked at supply chain dynamics, labor dynamics, global macro trends, whatever, and decided that continuing the Offers business is not worth the risk. There are easier and better ways for Zillow to achieve its stated goal. Fine, I’ll buy all of that.

With that said… why didn’t Zillow simply divest the risky, volatile, operationally troubled Zillow Homes unit? Why shutter it instead, and so quickly, and with such… little notice?

It isn’t as if corporate divestiture is some arcane, unknown practice. Here’s a Harvard Business Review article talking about divestiture as an important element of corporate strategy. It notes:

Some executives do understand the value of a well-planned divestiture program. Divestiture was, for instance, a cornerstone of General Electric’s strategy under Jack Welch—every bit as important as mergers and acquisitions. During the first four years of his tenure as CEO, Welch divested 117 business units, accounting for 20% of GE’s assets. Sandy Weill, now chief executive of Citigroup, made 11 significant divestitures while leading the Travelers Group through the 1990s, and he recently announced plans to spin off the Travelers Property Casualty business from Citigroup.

Jack frikkin’ Welch. Probably the most respected corporate CEO of the past several decades. He had a simple rule to determine whether to keep a business unit: “No. 1, No. 2, fix, sell or close.” You were either Number 1 or 2 in the market, or he would look to fix, sell or close you.

During his first two years as CEO of GE, Welch sold 71 businesses and product lines for $500 million.

So. Let’s say that Zillow Offers shit the bed. Let’s say that Zillow executives looked hard at what happened, noticed the risk and volatility, saw the underperformance, saw the difficulty of operating a business that buys, fixes, and sells houses during a global pandemic and supply chain issues and labor shortages. Let’s agree that Rich Barton and the rest of the team decided, “Hey, we need to get out of this business.” Fine.

There are two standalone businesses today that look an awful lot like Zillow Homes: Opendoor and Offerpad.

As of this writing (since I expect their stock prices to be changing over the next several days and weeks), Opendoor is a $12.7 billion publicly traded company. Offerpad is a $1.8 billion company.

Opendoor is #1 in iBuying. Zillow is #2. But whatever, let’s say Barton has lost faith and doesn’t want to run it anymore.

Why not sell it off? Why not spin it off? Why not divest the thing, instead of shutting it down?

If Opendoor is a $12.7 billion company, and Offerpad is a $1.8 billion company, you’re telling me that Zillow Homes as a standalone public company wouldn’t be valued somewhere in between? Like $8 billion?

Public companies do spin off entire divisions and business units as separate standalone public companies. Some prominent examples of such spinoffs include Paypal (from Ebay), Ticketmaster, LendingTree, and Match.com (all from IAC), Bath & Body Works, Victoria’s Secret (both from L Brands).

Zillow really couldn’t spin off Zillow Offers into its own public company, sign a longterm marketing agreement, figure out how to divvy up the staff and technology, and recover a few billion dollars in value? Really?

You’re telling me that with all of the private equity firms out there, some of whom specialize in buying “troubled companies” on the cheap and turning them around, Zillow can’t find one or two who might be willing to acquire Zillow Homes for a hugely discounted $4 billion or so? Really?

You’re telling me that with Rocket Mortgage looking every bit like it wants to become a brokerage, with Better launching W2 brokerages to improve their business, neither would have any interest in kicking the tires on Zillow Homes? Really?

This is the dog that did not bark. And it is the mystery that resists all solution.

Why wouldn’t Zillow simply spin off the Homes Division, thereby ensuring that the stable and profitable IMT business was insulated from and isolated from the risky and volatile Homes business? Or if not a spinoff, then a sale to someone else who might tolerate the risk more than Rich and his team can, and perhaps might feel that they will be able to overcome the operational and financial challenges better.

Instead, Zillow chooses to shut the whole thing down. Instead of trying to salvage a few billion dollars from its 3+ years of investment into the business, they choose to pay the separation and restructuring costs including the layoff of 25% of the staff. Just the COBRA costs from that alone is not insignificant. And the PR hit is not insignificant. The reputation hit is incalculable. Zillow’s air of invincibility, the inevitability of its ascendancy to the Iron Throne of real estate, is all but gone now.

I can’t understand it.

Alt-History: What Would Have Made Sense

Seeing as how we’re in a fiction-writing, speculative mood, let me give you a bit of an alternative history of how this could have gone down.

Homes has a terrible quarter. Mistakes were made. Algorithms made errors, compounded by operational flaws that led to a lack of capacity. Zillow had to write off $300 million, and eat a gigantic quarterly loss.

In response, Rich Barton comes on, announces the quarterly result, and says:

Yeah, we took a big hit. It’s embarrassing. I have taken a personal lead in ensuring this will never happen again. We will be making some new hires in the weeks ahead, starting with the world’s topmost experts in property operations. We will be bringing in the head of AI and data analytics from Palantir and Google. Because we’re Zillow, and we can afford those people.

This is a rough business, and boy, the risk and volatility are through the roof. We have $4 billion in cash though, so we can handle the ups and downs of being a market maker. It sucks, but hey, that’s why we’re the only company that can do this transformative thing. Some of you little guys and startups though… y’all need to know when the table stakes are too high for you. I’m talking to you, Redfin and Offerpad. Come back when your bank account grow up, son.

All of you brokers and agents rejoicing on social media that we took such a big hit, well, you tell me. How many of you can take a $300 million hit and just move on? Yeah, didn’t think so. If you want to bet your future on a partner, let me suggest you pick one that can take that kind of hit and shrug it off, okay? Otherwise, be quiet when the grownups are talking.

Having said that, we have come to recognize that trying to be both the top portal for real estate and the top market maker in housing is impossible. It’s trying to drive with one wheel, four hands, and two hearts. We’ve decided to fully separate the two units over the next couple of months, and we’ll spin off Zillow Homes as its own standalone business. If you think you can operate this tough market making business better than we can, we’ll listen to your offers. Call our investment banker, Chad McChaddison at Goldman Sachs.

By the way, just as a way to say thank you to our loyal partners, and to reassure our entire team here at Zillow, we’re changing our party at NAR San Diego. We’re renting out the Padres stadium, and Lady Gaga will be performing. Because we’re Zillow, and we can afford it, and I’m not a big fan of Aussie country music.

This alt-history is brought to you by the Native Tongue Posse, the Run the Jewels Fan Club, and the I Wannabe Elon Musk Society of North America.

I can’t help but point out that Tesla lost $717.5 million in Q2 of 2018. So during a conference call in May with analysts, Elon Musk called their questions boring, refused to answer them, and spent a lot of time talking to a YouTuber. Brass cojones, that guy.

Riddle Wrapped In a Mystery Inside an Enigma

I have to think further on what just transpired. I’ve only glanced through the earnings transcript; I think it deserves a more thorough study. The financials, I’ve only looked at in a cursory fashion. Perhaps they too deserve a closer look-see. And I am going to speak to as many smart, knowledgeable people as I can in order to form my opinions as to (a) what happened, and (b) what happens next.

Because to some extent, the mystery of this move is of historical interest. What is more pressing, more urgent is what this move now means for Zillow and for the real estate industry as a whole. What happens next is likely a more important inquiry, but it is one I simply cannot undertake tonight while I haven’t figured out some of the questions above.

Perhaps Olegba and Shango will be merciful and we will have Rich Barton on some lengthy podcast being interviewed by a knowledgeable host as to why Zillow did what it just did. Because the people who really know what happened and why they happened are almost entirely inside Zillow’s boardroom. And they’re not talking beyond what they have already said.

So let’s leave it here. Because like I said, my first hot take — like everyone else’s hot take — is likely wrong in some significant fashion. In my defense, my hot take consists mostly of incomprehension and question-asking.

I do not understand this move. I can’t get over the three giant gaping holes in the narrative. The alt-history makes far more sense to me, although I know the language and the attitude are completely not-Zillow.

I hope and kinda-promise (since hope is not a strategy) that I will have more actual takes and opinions on the next installment, when we consider not the past, but the future, and what this move means for Zillow, for iBuying, and for the real estate industry.

Thanks for reading this long-ass expression of befuddlement.

-rsh

3 thoughts on “Zillow Q3/2021: Riddle Wrapped in a Mystery Inside an Enigma”

  1. ROB,

    You and I have debated iBuying since their inception. There is a lot to talk about here but I would like to try and simplify the problem. I know you like the market-maker moniker so I’ll use my personal experience as a market-maker on the Chicago Board Options Exchange as a guide. My thoughts address the fundamental or core issue of iBuying. I think Rich mimics the same message without these specifics?

    Common invest-able assets such as stocks, bonds and commodities all have hedging instruments (options, futures) – real estate does not. So the only entry into the market is a naked buy leaving the market itself to determine winners and losers.

    This truth proves substantial risk to the program. These investment instruments have only three states – an up, stable or down market. Given iBuyers have a perpetual long position they are at enormous risk with a 66% chance of failure. A static or down market are capital killers and model busters. Only an up market allows for a profitable buy then sell.

    IMHO, this is the core problem. All the other stuff is derived from this fundamental flaw in the model.

    We’ll see.

    Thanks,
    Brian

    • That might be one issue, but I think the ZG and OPEN guys knew that there are no hedges for real estate.

      The bigger issue might be the long time lapse between purchase and sale. I don’t know how often traditional market makers have to sit on a BUY without a SELL to offset that.

      But at this point, I think I’ll wait to see what Opendoor’s earnings say about the market maker *model* versus what Zillow’s implosion says. Redfin’s report today suggest that the model is fine. Like I’m fond of pointing out, Wall Street traders lose billions in bad trades. That doesn’t mean the trading *model* is flawed; it just means that particular trader made a stupid bet.

  2. ROB,

    That is exactly my point. Very few professional traders/market-makers/investors make “bets”. Sure the locals make short term bets/trades, but they are just taking advantage of the order flow and scalping what they can out of their trade. Most leave the day flat with no position (“day-traders”).

    In my experience, it was extremely rare for a professional to buy without an immediate sale/short to off-set or lock in the risk.

    IMO, any model that includes betting on an outcome will have random market dependent results. Maybe call up the SEC and talk them into the validity of a liquid options or futures market instrument for real estate. With that, iBuying explodes to the upside as the (really) smart Wall Street quants come in with all kinds of strategies that allow them to buy at all price points – without the risk.

    I think we can simplify my point about the core model by experiment. Just buy a stock (naked) on margin.

    We’ll see.

    Thanks,
    Brian

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