Description

Zillow is the front door to US residential real estate. The company estimates that 2/3 of US home buyers use Zillow today, and Zillow currently touches only a MSD percentage of real estate transactions. The US housing market is one of the world’s largest asset classes, and the front door to that market is on sale for ~$8 billion, or about 3 basis points of the value of the asset class. The US residential brokerage industry generates more than $100 billion of revenue annually (~5% of the $2T+ in home values that transact each year) – this is split roughly evenly, half on the buyer’s side of the transaction and half on the seller’s side. 

Zillow’s dominant audience share, with 234m MAU per the Q2 2022 10Q, is the source of Zillow’s competitive strength and the foundation of its economic opportunity. In February 2021, SNL featured Zillow in a skit that analogized the satisfaction of browsing Zillow to that of romantic encounters. https://www.youtube.com/watch?v=yEfsaXDX0UQ

Historically, Zillow has monetized this audience by selling advertising to real estate agents who want to connect with Zillow’s users and convert interested shopper leads to home buyers. The ads were priced on a CPM basis, and the price was determined functionally like an auction. This was called Market-Based-Pricing (MBP). Importantly, for most of Zillow’s history, they have only monetized the prospective buyer side of the transaction. The advertising agent paid out of pocket for the ad up front, and hoped to convert a low percentage of the acquired leads to a home purchase. The purchase would usually close several weeks after paying for the ad. This working capital pinch felt by agents has historically limited Zillow’s ability to increase its share of economics generated by its platform.

Zillow currently under-monetizes its powerful position in the real estate ecosystem. Shoppers using Zillow likely account for many billions of dollars in real estate commissions, and in 2021 Zillow captured ~$1.4 billion of those dollars in its PA business (2021 10K). In 2018, Zillow introduced a new revenue model for its Premier Agent advertising business, called Flex. Flex shifts the payment structure from up-front cash to at-risk, contingent consideration paid at closing of the transaction. Zillow takes the risk, and as a result the agents pay Zillow a high share of commissions (usually 30-35%, per https://www.zillow.com/premier-agent/flex-pricing/), but only at closing. This change has several effects. In some cases, Flex may yield a meaningful increase in monetization per closing. In addition, and perhaps more importantly, Flex lets Zillow funnel leads to the highest performing agent teams, instead of whichever team happens to win an ad auction. This increases conversion rates. The Flex teams do not have to spend advertising dollars up front (months before recouping those investments at closing), and can instead invest the working capital into resourcing their business, enabling better responsiveness and more complete prospect coverage. These changes can serve to increase close rates, and the customer is provided a superior experience (by being connected to a more responsive, higher-quality agent).

The Flex program is a superior economic proposition to Zillow, a superior economic proposition to the agent teams (they can grow their business much faster with no working capital constraints, and convert more leads given more robust resources to serve those leads), and a superior customer experience for the user. Flex also consolidates Zillow’s influence in the ecosystem, because Zillow gets to hand out high-quality leads to any team it wishes, and the agent teams have no recourse if Zillow decides to send all the leads to a competitive team.

The near-term opportunity to increase economics to Zillow via Flex is likely significant – as Flex becomes a bigger driver of the total PA business, it is not difficult to imagine the business being much bigger in a small number of years, with quite high incremental margins. Importantly, this growth requires no incremental increase in customer behavior (no growth in total leads is needed).

In addition to the increasing share of transactions facilitated by Zillow (higher volume) and higher revenue per transaction (higher price), Zillow is well-positioned to sell other products to home buyers and sellers. The most obvious opportunities are in mortgage origination and closing services. Zillow has made inroads in recent years in both categories, acquiring businesses to serve as the foundation for their offerings. Both opportunities are significant for two reasons – they do not require massive capital intensity or balance sheet risk, and they each carry high revenue per transaction compared to MBP or Flex leads. Small increases in attach rates of these products have outsized impacts on Zillow’s revenue per transaction. A Flex closing might generate ~$3,000 in revenue to Zillow, whereas a mortgage origination on that same house might have ~$9,000 in revenue to Zillow. Adding closing services (title/escrow) would mean another ~$2,000 in revenue per transaction. 

There is good reason to believe that Zillow is well-positioned to have high penetration in mortgages and closing services. In 2021, Lennar Corporation (LEN) originated mortgages for 75% of its homebuyers (page 27 of LEN 10K for 2021). Mortgage origination is fragmented – Rocket Mortgage, the largest originator in the country, has small market share (and is worth several multiples of ZG’s EV).

It is still unclear to me that iBuying is a business with viable economics at scale and through a housing cycle, but what is clear is that Zillow has ways to provide products and services to sellers that do not require being the counterparty and risking the company’s balance sheet. There are several possibilities, one of which was announced with Q2 2022 earnings. It appears the partnership with Opendoor will enable Zillow to earn a referral fee on sales while the partner takes the balance sheet risk. No matter which form these products take, they will almost certainly be higher margin and lower capital intensity than the business Zillow has just exited. I don’t think any success in the seller market is required for appealing returns from here, but to the extent the company does gain traction, it is a very large opportunity.

The leadership of Zillow is a key strength – Rich Barton is an impressive entrepreneur with a track record of success and is well-aligned with shareholders. He now has a tool available to him that he hasn’t previously had – a pile of cash. Since the announcement of the iBuying exit, the company has been buying stock back aggressively. A $750m authorization was announced on December 2, 2021. The company bought $302 million in that month at an average price over $61. This continued in Q1, when the company bought another $348 million of stock at an average price close to $60. In Q2, the company bought $249 million more at average prices in the high $30s.

The controversy surrounding the iBuying exit, and recent concerns over a housing market slowdown, have emptied the perception glass so much that the company trades for ~12x consensus 2022 EBITDA. This business should be generating hundreds of millions of dollars per year in free cash flow, and the company should have meaningful net cash after the Homes wind-down. It is from this position of strength that Zillow will be able to play offense by continuing to develop (higher margin, lower capital intensity) products for home buyers and sellers.

The runway for Zillow is long – despite massive share of consumer activity and a dominant position in its ecosystem, Zillow’s revenue is a LSD % of real estate commissions in the US. The company has quietly been implementing an elegant system to increase conversion and consolidate control of the lead market.

Key risks include a general housing market slowdown – I think Flex positions Zillow to outgrow the market (defined as home sales x average home price) but macro headwinds could make the absolute growth rates very hard to achieve. This challenge was demonstrated pretty clearly in the company’s Q3 outlook. If the company is unable to turn more markets to Flex over time and/or has difficulty attaching ancillary services, the revenue per transaction targets will look even more optimistic. 

Disclaimer:

The views and opinions stated are the personal views of the author. Do not rely on the information set forth in this write-up as the basis upon which you make an investment decision – please do your own work. The author and funds in which the author manages hold positions in and trade, from time to time, securities issued by ZG and options on such securities.  This write-up does not purport to be complete on the topics addressed, and the author takes no responsibility to update this write-up in the future.  This is not a recommendation to buy or sell any securities.

Catalyst

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