July 1, 2022

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Anything but ordinary

Zillow Will Always Be A Real Estate Titan: Buy Z Stock For The Long Haul

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I’ll admit it’s difficult to go against the grain and invest in battered tech stocks when it seems like all the smart money is running the other way. Zillow Group, Inc. (NASDAQ:Z) has had its fair share of pain this year. Alongside general angst for tech and growth stocks, Zillow is also doubly facing the slowdown of the housing market, which is starting to eat into the growth rates of its flagship Premier Agent business, while it also continues to work through a complex wind-down of its iBuying strategy.

Zillow just released Q1 results, and investors were not happy with the deceleration implied in the company’s forward-looking guidance. The stock slipped ~10% directly after earnings, with Zillow’s year-to-date losses now bubbling above 40%:

Chart
Data by YCharts

Yes, there is noise here: but can investors stick to focusing on the long term? I remain bullish on Zillow, with this core principle in mind: the real estate market will always have cycles, in the exact same way the stock market does. Investors punishing Zillow for this natural seasonality is senseless. Instead, focus on the bigger picture of the platform that Zillow is building to capture more wallet share within consumer real estate, and have confidence in the fact that Zillow remains the most-visited real estate website today.

Q1 download

Let’s first give a quick recap on how Zillow’s business performed in Q1 and the red flags that caused the stock price to drop. The Q1 earnings summary is shown below:

Zillow Q1 results

Zillow Q1 results (Zillow Q1 shareholder letter)

Now, without any context and looking just at numbers, it would seem that Zillow is exploding. Revenue more than tripled y/y to $4.26 billion, but you’ll note that the lion’s share of this came from the $3.72 billion of revenue in the Homes segment. You’ll recall that last year, Zillow made the choice to wind down its iBuying activity and is unloading its portfolio of homes (an excellent time to capitalize on still-high real estate prices as well).

The IMT segment, however, which is Zillow’s flagship business and will be virtually all of its revenue in the post-iBuying world, saw revenue grow at 10% y/y to $490 million, which represents four points of deceleration versus 14% y/y growth in Q4.

Premier Agent revenue, meanwhile (the revenue cut that Zillow takes when real estate agents advertise on Zillow), grew 9% y/y, also decelerating four points from 13% y/y growth in Q4, while rental revenue decayed -5% y/y. This was driven by high occupancy rates in the U.S. and a slowdown in rental advertising.

Ditto for the mortgages segment: mortgages saw a -32% y/y decline, driven by the continued tightness of housing inventory plus the slowdown in mortgage applications due to sharply rising interest rates.

Driven by decelerating revenue and the technology investments that Zillow is continuing to make into the IMT business, IMT segment adjusted EBITDA margins peeled back 400bps to 43%:

Zillow Q1 adjusted EBITDA

Zillow Q1 adjusted EBITDA (Zillow Q1 shareholder letter)

Here’s some additional helpful color commentary from CEO Rich Barton’s prepared remarks on the Q1 earnings call, detailing the dynamics the company is witnessing in the housing market:

Before we get into our results for the quarter, I’d like to spend a little time talking about the housing market given it’s on everyone’s mind. There is a dispersion of real estate forecasts among publishing economists that range from 5.5 million to 6.5 million existing home sales for 2022 compared to 6.1 million in 2021. This results in a transaction growth rate range of negative 10% to positive 7%.

The common thread across these forecasts is uncertainty for the housing market. We continue to see low levels of inventory down 23% year-over-year in March. New for-sale listings were less strained in March, up 36% from February levels, but still down 9% year-over-year.

Average page views per listing were at a record high in Q1, which results from low inventory, yes, but also signals a strong intent to move. These dynamics drove home values up an astonishing 21% year-over-year in March despite rising interest rates, which, of course, exacerbate affordability challenges.

So while we know people are still eager to move, market conditions are making it increasingly difficult. The net result of all of these factors is that total consumer transaction value growth trends are meaningfully softening and even the most respected prognosticators have disparate views of what will happen next.

Despite this turbulent housing market, Zillow is positioned as the leader at the top of the real estate funnel stands firm with 2.6 billion visits in Q1, including a 38% unique visitor growth year-over-year in rentals according to comScore.”

Looking ahead to the future

Okay, so that’s what is happening right now; but what about the future? Zillow continues to aim for targets of:

  • $5 billion in revenue by 2025
  • A 45% adjusted EBITDA margin when it hits that scale, or ~$2.25 billion in annual adjusted EBITDA.

I’ll continue to emphasize my general thesis: while the real estate market will always have its ebbs and flows, what investors should be grounded on is Zillow’s continued hold over consumers and the improvements it’s making to its platform.

The company continues to add new features that encourage home-buyers to take action. In Q1, the company made improvements to its virtual home-touring experience to combine photos, floor plans, and spatial perspective into a more coordinated digital experience. For in-person tours, the company also added the ShowingTime Real Time feature in many markets, which gives exact times that homes are available for an agent tour.

Beyond this, here’s a rundown of all the reasons I remain bullish on Zillow in the long term:

  • Exit from iBuying shines the spotlight on margin-rich IMT segment. In 2021, Zillow’s core IMT segment (which generates fees from real estate agents finding clients on the Zillow site) saw its adjusted EBITDA margins expand to 45%, up from 38% in 2020. That indicates a revenue stream that is nearly pure profit and very minimal overhead, and directly correlated with the uptick in real estate activity. To me, removing the distraction from iBuying and its horrendous quarterly losses will have the effect of expanding valuation multiples for Zillow’s profitable core business.
  • Across Zillow, Trulia, StreetEasy, and Hotpads, virtually every American consumer thinking about buying or renting a home will come across one of the Zillow Group’s websites. Zillow has built an ecosystem rich with real estate data that has become the forefront of online real estate for users. Zillow traffic reached a record high of 10.2 billion visits (+6% y/y) in 2021.
  • Zillow is a platform that can add a whole suite of additional monetizable services. With all this traffic, Zillow’s ability to generate tertiary revenue is broad. Currently, the majority of Zillow’s business comes from advertising fees paid by real estate agents, but the company is also expanding into distributing mortgage products as well. In the future, Zillow could offer a full suite of “after-market” home add-ons, including house insurance, moving services, furnishing/interior decoration services, and others.

From a valuation perspective, it’s a very attractive time to invest in Zillow. At current share prices near $36, Zillow trades at a market cap of $9.15 billion. After we net off the $3.63 billion of cash and $1.74 billion of debt on Zillow’s most recent balance sheet, the company’s resulting enterprise value is $7.27 billion.

Looking backward at the $853.2 million of adjusted EBITDA that the IMT segment generated in FY21 (ignoring the losses in the Homes segment, as we should effectively think of that as discontinued operations going forward), Zillow’s valuation is at 8.5x EV/trailing adjusted EBITDA. If we look ahead to the company’s 2025 goal of $5 billion in revenue at a 45% adjusted EBITDA margin ($2.25 billion), Zillow is potentially currently trading at just ~3x its future EBITDA potential. There’s a lot of room here, in my view, for upside.

Key takeaways

Take advantage of the market’s recent fear to build a long-term stake in Zillow. Looking ahead, Zillow continues to be the dominant consumer real estate website that enjoys the lion’s share of web traffic. Its online advertising/Premier Agent business continues to be a top marketing channel for real estate agents, and the revenue stream comes in at a very high EBITDA margin already. Stay long here.