The past two years have seen immense volatility in the U.S housing market. As mortgage rates collapsed and people made lifestyle changes, home sales skyrocketed. Unsurprisingly, this led to a surge in property prices, new home development, and household debt. Additionally, many stocks within the real estate industry rose dramatically, including the internet-based company Zillow (NASDAQ:Z), which grew ~500% from its 2020 trough to its early 2021 peak.
I was one of the earlier skeptics of Zillow’s rally, as detailed in November of 2020 in “Zillow Group: Reversal Of ‘Housing Boom’ Creates A Short Opportunity.” My bearish thesis was that the housing boom would inevitably lead to a crunch once mortgage rates rise. Combined with Zillow’s high debt due to its (now defunct) home buying program and the fact that internet-based companies face more significant competitive pressure, it seemed to me that Zillow’s sky-high valuation was not sensible. In general, this thesis has proven correct as the stock is currently down by nearly 50% since the article was published, and its buying-selling program has shuttered.
Is Zillow Finally Trading At Fair Value?
Of course, when any stock is down 50%, it is an excellent time to reassess its situation to see if it is finally trading at a reasonable valuation. At the same time, the company continues to face competitive pressures and, more importantly, skyrocketing mortgage rates have resulted in massive declines in home sales. Whether or not the spike in mortgage rates causes a substantial and lasting crash in the property market remains “too be determined,” however, the macroeconomic backdrop has undoubtedly turned against Zillow’s favor. This shift has occurred at an inopportune moment as the company is desperately looking to change its business model to move past its recent missteps.
The company’s shifting macroeconomic backdrop can be seen in the inverse correlation between pending home sales and average mortgage rates. When mortgage rates fall, more homes are sold at higher prices. When they rise, the comparative value of renting over buying increases, causing home sales to decline. See below:
The steep pace at which mortgage rates have risen is particularly notable. This spike proceeded the recent end to the Federal Reserve’s colossal mortgage-backed-security purchase program, which artificially held mortgage rates down and thereby supported the housing market. Since 2020, the Federal Reserve has been, by far, the most significant mortgage financier on the market. Now that the Q.E era has officially ended, bond liquidity has declined, as it turns out private bond investors are not so willing to invest at rates well-below inflation.
Accordingly, given the ongoing energy crisis is set to exacerbate further inflation, mortgage rates may rise considerably higher before reaching a new steady-state. While inflation is not directly negative for the housing market, its impact on mortgage rates could bankrupt many private mortgage lenders – mortgage REITs in particular. Problematically, as last seen in 2008, a decline in mortgage financier’s solvency could freeze the mortgage lending market, dramatically hamper home sales volumes. At the same time, rising gasoline and general inflationary pressures leavings homeowners with lower free disposable income, potentially resulting in higher default rates and lower home prices.
In my view, these are the most critical bearish factors for Zillow since the company’s sales are tied to mortgage and property agent referrals. If home sales volumes decline and the market remains slow for years, as I suspect, then Zillow’s growth potential is limited. Fortunately, the company managed to offload the vast majority of its “iBuy” homes, so its direct exposure to a potential decline in home prices (due to rising rates) is far lower than when I covered the company last.
Management Changes Offset Macro Losses?
There is always another side to the coin. If its growth strategy works as expected, the stock may be trading at a slight discount today. Unlike mortgage REITs and home developers, Zillow has a greater capacity to make business model adjustments to remain afloat during times of turbulence. Additionally, as detailed in Zillow’s last investor presentation, 67% (12.2M) of all U.S home buyers use Zillow today, but, in 2021, only 360K of those made “customer transactions” with the firm. These include using a “premier agent,” mortgage sales, or Zillow’s closing services.
Zillow is currently leaving a lot of money and could see immense sales growth by only marginally increasing the number of total customers (12.2M) who make a transaction. Fortunately, the company has given a clear model for the impact of an increase in its customer transaction share:
In my opinion, these are not unreasonable estimates. Zillow has a solid customer base and has emerged as the dominant source for finding new homes. Given the convenience of finding a realtor (etc.) through their platform is likely attractive to younger homebuyers, increasing customer transaction share from 3% to 6% over the next three years seems feasible. Thus, I would not be surprised to see a doubling of its total revenue from now to then. Still, based on my economic views regarding today’s shifting property market, I suspect Zillow may see a decline in customers as home sales activity declines. If the company can increase customer transaction shares sufficiently, this may not harm Zillow’s revenue.
However, I believe that agent sales commissions will likely decline significantly below the traditional 6% as demand for homes declines. Services like Zillow that streamline and simplify the homebuying process generally mean less work for real estate agents, particularly decades ago when this work was all done through physical mediums. Zillow’s market dominance in this industry may also be its detriment due to the potential for monopoly-power lawsuits and negative pressure on commissions. The real estate industry is among the few where commissions are still extreme, and Zillow capitalizes on obtaining a portion of those commissions. While many have long suspected that internet services will result in lower commissions, I believe this will only occur once there is a bear market period in the housing market as that would create a large “agent glut.”
There have only been marginal declines in realtor’s commissions, so it may be some time before this potential shift impacts the company. However, it remains possible that both revenue-per-customer and total customers decline. The trick for Zillow will be to increase the share of paying customers to those who “window shop.” Given that the specific ratio remains relatively low, it seems possible that Zillow can go through a real estate bear market without losing revenue and could even see revenue increase despite it.
Still, Zillow has been unable to become consistently profitable. The firm has had negative margins for years and has been highly dependent on debt growth and equity dilution to maintain its cash levels. Of course, this is mainly due to its unprofitable home flipping business while its IMT segment (which the company intends on growing further) has had better profitability. Still, there is a clear trend of Zillow’s EBITDA margin being below the expected value:
The company believes it will see its EBITDA margins rise from near-zero to over 39% over the coming year. Given it is no longer focusing on its money-losing segment, this may be true, but I will still take this outlook with a grain of salt. The firm’s current consensus 2022 EPS estimate is $1.85 and up to $3.45 by 2024. I believe these estimates are feasible, though, given the macroeconomic situation, the solid expected 2022-2025 growth may not be so easy. It is easy to proper in good times but much more difficult when tides shift.
The Bottom Line
I am no longer firmly bearish on Zillow and would not bet against the stock. When I covered the stock last, its home-flipping business gave it excessive exposure to the downturn in home sales that would come with rising mortgage rates. However, Zillow’s management was intelligent enough to reverse course and sell its home assets, commendably doing so (potentially) at the cyclic peak of the U.S property market. While a bearish shift in the housing market will almost certainly create issues for Zillow, it has a greater capacity to weather the storm than most.
Zillow’s path to profitability and higher revenue is fundamentally sound, but uncertainty remains very high. I suspect that if there is only a minor slowdown in home sales, Zillow may indeed grow its annual revenue to $5B by 2025. In my view, a more significant decline in homes sales akin to, but not necessarily as dramatic as that of ~2007-2010, would likely upend Zillow enough to remove its growth potential. If the real estate industry’s arguably excessive fee structure finally declines, then Zillow may see some declines in sales since it aims to capture much of these fees.
At this point, I would not buy Zillow’s stock as I believe it is trading near its fair value. The company is currently trading at a forward “P/E” of 30X, and if its growth expectations pan out and its EPS doubles from 2022 to 2025, then its long-term forward “P/E” would be around 15X today. Long-term data suggest mature companies tend to trade at a 15X “P/E,” though many “mature” firms have traded at far higher valuations over the past decade. Though I doubt Zillow’s growth potential, they are no longer strong enough to suggest that Zillow is substantially overvalued today. Still, I am only willing to buy a stock if I believe it is dramatically undervalued, particularly with uncontrollable economic risk factors such as Zillow.