Description

Price = $50.67

52 wk high = $212.4

52 Wk low= $44.08

Shares outstanding= 254.8 M

Long Term Debt = 1,766 M

Last 12 Months EPS = -$.63

Last 12 months Rev = $5,054 M 

It took a lot of humility for founders Rich Barton and Lloyd Frink to pull the plug on Zillow’s iBuying venture, Zillow Homes, after this “Big Swing” lost approximately $1 B of shareholder value.  That loss particularly stings as they combine own 9.8% of the company.  Rich and Lloyd met at Microsoft in the 1990’s where they built Expedia, disrupting the offline travel industry.  They discovered that the residential real estate industry was the next perfect industry to target after selling Expedia to Barry Diller.  Real Estate information was opaque to the consumer at that time and the founders vowed to turn the lights on for home shoppers by putting the data online.

Today, with > 200M monthly active users and 2.7B monthly visits, Zillow maintains 70% of user engagement traffic share in the U.S.  Realtor.com is a distant second with about 25% of Zillow’s traffic and declining since the COVID pandemic.  Redfin is in third place with approximately 17% of Zillow’s traffic.   Many analysts mistakenly view Zillow’s business as bumping up against a TAM of Total Agent Commissions but I strongly disagree.  Zillow 2.0 is all about providing an A to Z transaction experience for the home shopper.  Zillow management is clear about this strategy and the appropriate way to look at their future opportunity is the approximately $2T U.S. single family homes transacted in 2021.  If Zillow is successful in building an operating system for home transactions in the U.S., an enormous high margin revenue business from even a small take rate on this TAM could be built in the next 3-5 years.

In today’s digital economy, every company is chasing the golden goose – building a PLATFORM with its massively monetizable network effects.  We all know some winners of the platform races – social networking = Facebook, professional networking = LinkedIn, non-fiction video sharing = Youtube, etc.  But, the list of companies that ultimately failed to gain platform status is much longer.  And that’s because getting to a scaled platform/network is extremely difficult.  First mover advantage is certainly a big win, but just ask Friendster and MySpace if it’s impenetrable.  However, if you’re fortunate and wise enough to get to scale, a platform is capable of getting on the flywheel of massive monetization through those scale network effects that accrue.

Zillow’s goal is to be THE platform/operating system for residential home transactions moving its highly engaged users further down the transaction funnel from where Zillow monetizes today which is only the lead it gives to a real estate agent.  As they incorporate mortgage/title/closing services, Zillow will further monetize the $2T U.S. single family housing transaction industry.

Zillow is a great long opportunity now that they're shutting down its Zillow Homes segment.  In my opinion, there are three reasons why iBuying of homes is a terrible business.

#1  Adverse Selection – Despite Zillow having great real-time data to price their offers for homes, they don’t know as much as the home seller.  If a home seller hits their bid, they don’t want to buy her home.  It’s analogous to trading a stock when the other side of the trade has inside information. 

#2  Pro-cyclicality – When a particular market’s home prices are about to fall, Zillow is going to get executions as home sellers find it difficult to sell traditionally at the exact wrong time, thereby owning housing inventory in a down cycle.

#3  Zillow’s brand tarnished – Less than 10% of Zillow’s offers were accepted.  Home sellers are left with a bad experience when they believe Zillow lowballed the offer.  The hope was that the rejected offer would result in a seller lead, but in practice, home sellers typically choose an agent they know in their community rather than a random agent Zillow recommended.

Now, a brief review of the current financials of Zillow Group’s business:

At a stock price of $50.67 as of 2/1/2022, 254.8 Million shares outstanding, $3.2 Billion in cash and cash equivalents, and $1.8 Billion in Recourse Debt; Zillow’s EV is $11.51 Billion.

It is extremely important to understand that the credit facilities and securitizations backing the Zilllow Homes business is NON-RECOURSE to Zillow Group.  This total debt of $2.9 Billion is ring-fenced within the Variable Interest Entities (VIEs) and can only be paid off with home inventory proceeds.  To the extent that the proceeds of inventory liquidations are insufficient to make whole on the facilities/securitizations, Zillow does not have any obligation to pay the difference.  Essentially, Zillow’s losses in their iBuying fiasco have already been taken through the cash out the door when the homes were purchased through the 10% down payment.  No further cash will be lost during the wind-down of Zillow Offers; I actually forecast about $75M in cash generation from the wind-down.

On to the remaining segments of Zillow Group: IMT (comprised of Premier Agent, Rentals, and New Construction) and Zillow Mortgages.

Internet/Media/Technology: TTM REV = $1.83 B

                                             Adj. EBITDA = $836.3 M

Zillow Mortgages:                TTM REV = $256 M

                                                  Adj. EBITDA = $19.2 M

TOTAL ZILLOW GROUP (ex Offers):  TTM REV = $2.09 B

                                                                   TTM Adj. EBITDA = $855.5 M

                                                                   TTM Adj. EBITDA Margin = 42.6%

As for Cash Flow, Zillow has very little CapEx requirements to run its digital real estate platform, and has averaged $73 M in CapEx (mainly for IT infrastructure) over the past 3 years.  Assuming a tax rate of 20%, TTM Free Cash Flow = $611 M giving Zillow Group a Free Cash Flow yield of 4.7% today.

Zillow is uniquely positioned to offer related services such as pre-qualification/mortgage, title, and closing services given its trust with the home shopper and highly engaged users.  With Zillow’s ownership of Dotloop, the premier real estate transaction workflow application used by agents to digitize the transaction process for clients, home buyers and sellers can seamlessly sign documentation all within the Zillow app/website.

 The highly strategic acquisition of ShowingTime for $500M closed in November 2021 will allow home shoppers to schedule showings directly within the Zillow app without speaking with an agent.  ShowingTime is the tool that listing agents use to upload lockbox codes and is essentially the “Calendly” for real estate showings.  This will greatly improve the efficiency and experience of home shopping which will lead to improved conversion.

Now let’s discuss the dynamics regarding how Zillow currently monetizes their vast user engagement and how this is going to change dramatically over the new few years.

Zillow monetizes today primarily through buyer agent leads.  Seller agent leads is a small percentage of their business (approximately 10%).  Zillow gets automated feeds of home listings directly from MLSs and brokerages across the US and sells advertising to buyer agents looking to assist home shoppers in buying a home.  Most of the mechanism today for this is through an auction-based system, where the agent who bids the highest amount, gets the lead ad impression during a view of a home on the site.

The price an agent is willing to pay is a function of three things:

1.    The price of the home (higher the price – larger the commission on a successful transaction)

2.    Expected conversion rate (higher the probability of converting lead to a transaction – higher the price agent will pay for the lead)

3.    Agent’s ROI demand (Some agents need a 5x on their leads spend to justify a price but others could do it for much less)

From Zillow’s perspective, they make the most per lead as the auction system results in the highest bid for the lead impression.  HOWEVER, this system does not optimize the home shopper experience necessarily which is a problem for the business long term.   Industry consensus points to only approximately 5% of online leads are converted to an ultimate transaction (and commission).  For Zillow, it’s in their best interest to improve this as it not only improves Zillow’s utility to the home shopper, but also improves monetization as agents are willing to pay higher for leads if they convert better.  There are ways that Zillow can directly improve conversion such as integration of ShowingTime and offering 3D virtual tours of homes for example, but a lot of conversion is up to the expertise and quality of the agent.

Zillow has figured out that this auction-based system is not the best method for long term success of their platform.  Instead of the lead going to the highest bidder, Zillow is migrating its entire monetization strategy to something called “Flex”.

This is an enormous pivot and the market doesn’t understand it in the least.

Flex works like this:  Instead of the agent paying upfront for a lead; the agent pays nothing upfront and instead only pays Zillow a “referral” success fee upon a closed transaction which is between 25-35% of the commission earned.  Initially trialed by Zillow in 2018, Flex leads are a radical game changer.

First, Zillow CHOOSES the real estate agent who works with the home shopper.  The bar for being accepted into the Zillow Flex program is high.  Most agents on Zillow’s platform are not invited to participate.  The primary metric used to determine participation is conversion rate.  Essentially, Zillow goes zip code by zip code and invites the best converting agents to join Zillow Flex.  Now understand that these are not individual real estate agents per se.  These are AGENT TEAMS.  This phenomenon has gradually occurred over the past 5 years in the real estate industry as a result of changing consumer expectations in today’s on-demand, instant gratification world.  Real Estate agents are expected to pick up a call from a prospective client no matter what and not doing so results in a lost lead.  So, the industry has adapted whereby an agent always picks up because they are part of a Team with systems in place to assure leads are connected instantly without lost calls.  Because if an agent doesn’t pick up, the prospect will move on to someone else.  That’s what it’s like in today’s on-demand, digital world.

What’s interesting is that at the initial launch of Flex in a small number of markets a few years ago, management used to speak a lot about it.  Today, very little about Flex is disclosed.  I think it’s an intentional downplay by Zillow for the following reason:  Flex is resulting in a lot of pissed off real estate agents who are essentially being removed from the Zillow platform.  Whereas under the auction-based system of lead allocation, the lead went to the highest bidding agent, not necessarily the highest converting Agent;  Flex leads go to the highest converting Agent Team.  This means the overwhelming majority of real estate agents previously working with Zillow in the auction-based lead allocation system are being told by Zillow, “Thanks but No Thanks.  We are optimizing for consumer experience and there’s someone else that converts better than you!”   This is the beginning of the Great Purge of real estate agents.  And the almost 1,000,000 mostly part-time registered real estate agents in the US are not getting leads from Zillow regardless of what they are willing to pay.

There are a few reasons why Flex is great for Zillow and its Agent Team partners. 

For Zillow, leads are given to the highest converting Teams, and thus maximizes lead conversion which maximizes transactions which maximizes referral fees to Zillow.  Giving leads to the highest converting Teams also optimizes the consumer experience on Zillow because consumers’ north star ultimately is to buy a home as efficiently as possible.  Optimizing the consumer experience reinforces the moat around consumer engagement with Zillow services which further distances its lead versus its competitors such as Realtor.com and Redfin.

For the Agent Teams, and this is really interesting; Flex changes the ROI calculation completely.  Whereas with the auction-based model, all Agents and Agent Teams competed on equal footing, now with Flex, only scaled Teams with best practices’ systems that can maximize conversion receive leads.  Gone are the individual agents, replaced by Teams with team leaders who are businesspeople, not  real estate agents per se any longer.  When they don’t have to shell out any capital upfront to pay for leads, the ROI calculation changes enormously, analogous to a Facebook direct response ad, whereby the SMB is willing to pay just about anything that results in even a small positive ROI because it’s associated with a revenue transaction and thus positive profit contribution.  Better explanation:  If you are an individual real estate agent bidding on Zillow in the auction format.  In a particular zip code let’s say there are 1,000 transactions per year and you are 1% of the market. You close 10 transaction sides a year, $400k average transaction, 2.5% commission, resulting in income of $100,000 to you in your real estate business.  You need to feed your family, so you are willing to pay Zillow $10,000 so you net $90,000. That’s a 10x ROI to the agent ($100k gross income, $10k paid for the leads)   Now, think through how this works with Zillow Flex.  As a Team Leader, you continue to win more and more lead allocations as long as you have the highest conversion to the point where you are the exclusive Agent partner in a particular Zip Code.  You do 1,000 transactions per year and are 100% of the market in the zip code.  Same $400,000 avg. transaction, 2.5% commission, results in gross income of $10,000,000 to the Team.  30% Flex “referral” fee to Zillow is $3,000,000 to Zillow for the leads and your net income is $7,000,000.  In the auction-based model, Zillow gets $10,000 per agent X 100 agents = $1,000,000 TOTAL REVENUE vs. $3,000,000 TOTAL REVENUE under the Flex model.  A 3X in Revenue for Zillow for switching a zip code from Auction to Flex!

Another huge benefit to Zillow from switching from Auction to Flex is the SG&A savings.  Whereas with the auction-based system, Zillow had hundreds of customer success and sales reps to manage relationships with tens of thousands of agents, with Flex, Zillow needs significantly less headcount to manage relationships with the few remaining Agent Teams that have their own people and systems in place.  Essentially, Zillow is outsourcing all of that expense to the partner Teams in the Flex model of lead distribution – resulting in a much more profitable business for Zillow overall.

Today, Flex is only about 10% of Premier Agent business vs. auction-based. and is dramatically more profitable.  As Zillow eventually rolls Flex out to all zip codes, the math results in a tripling of Zillow’s revenue.  That’s before the flywheel effect of a better consumer experience resulting in more lead opportunities through higher consumer engagement with Zillow.

Speaking with some Flex Team Leaders, they absolutely love Flex.  It  sets up this competition among these agent team leaders in all these markets to get better and better at converting leads knowing that Zillow will give them more and more market share.  It's a brilliant systems’ engineering profit optimization solution.

There's a reason Zillow has stopped talking about Flex publicly.  Brokers and agents are pissed.  They're being told they're no longer going to get leads, no matter what they bid.

Finally there will be the long anticipated Real Estate Agent Purge in the US and will not only improve Zillow's transaction take-rate but will more importantly improve the home shopper experience and loyalty to Zillow because the only agents available on the platform will be those who optimize the customer experience.

Also, they're making great strides with integrating mortgage/title/closing.

The bottom line is they have such a large audience and trusted brand (>200M monthly visits) and now that the iBuying fiasco has been de-risked, with $900M EBITDA at only 10% Flex penetration,  with plenty of room for increased integration of other services, Zillow at $13B EV is stupid cheap.  Zillow is best positioned to deliver a fully digital, seamless, and integrated home buying/selling experience that everyone expects in today’s instant gratification, on-demand digital world.  Home shoppers want to push buttons on their phone and make magic happen.  Zillow is without question the best positioned to deliver that experience in a $2T real estate transactions industry.

Catalyst

Today, Flex is only about 10% of Premier Agent business vs. auction-based. and is dramatically

more profitable. As Zillow eventually rolls Flex out to all zip codes, the math results in a tripling of

Zillow’s revenue. That’s before the flywheel effect of a better consumer experience resulting in

more lead opportunities through higher consumer engagement with Zillow.

Speaking with some Flex Team Leaders, they absolutely love Flex. It sets up this competition

among these agent team leaders in all these markets to get better and better at converting leads

knowing that Zillow will give them more and more market share. It's a brilliant systems’

engineering profit optimization solution.