Description

Zillow is the starting point for nearly every American consumer’s home buying and selling journey.  This should be a very valuable position in a massive, highly fragmented, and largely backwards industry.  But historically Zillow has struggled to adequately monetize their tremendous audience. That is changing and Zillow has the opportunity to be worth multiples of the current market valuation if they are successful in penetrating only a fraction of their addressable market in the coming years. 

 Zillow has nearly 200 million monthly unique users and their traffic accounts for more than 70% of all online real estate browsing in the United States.  Zillow cemented its position as the dominant position for classified real estate information in the United States after its acquisition of Trulia in 2015.  Numerous well-funded and entrenched competitors have attempted to displace Zillow but they have largely failed to put a dent in Zillow’s audience share. Unlike similarly situated real estate classified businesses in countries outside of the US, Zillow has had to contend with local multiple listing services which aggregate a given county or state’s property listings and provide a feed of these listings to all of their member agencies so that these agencies could include listings for all available properties in a region on their own website rather than only those for which they maintained the coveted position as the sellers’ agent.  The fact that local listings were already being aggregated before Zillow was founded helps explain why the Company has never been able to monetize by charging a fee per listing in the same way as real estate portals like RightMove in the UK and REA in Australia.

 Zillow’s historical means of monetization was selling leads and marketing software to Premier Agents who rely on Zillow’s traffic as a source of leads for selling homes.  Zillow sells leads on a cost per impression basis and the impressions are delivered when a home shopper sees the name of a participating agent next to a home they are interesting in touring.  The consumer can opt in to be contacted by the Premier Agent to see that home and others within their area. Conversion to sale for these leads is low in part because many potential home buyers already have a relationship with an agent that was established offline prior to discovering an interesting listing on the web.  Zillow is trying to increase the ROI associated with their leads by increasingly pivoting to a program where Zillow receives a share of commission dollars earned by participating agents that end up representing a Zillow-sourced buyer at closing. By moving down the funnel and more closely tying Zillow’s monetization to the transaction event, Zillow is shifting focus from quantity of leads to quality of leads.  The Company believes that doing so will allow them to increase revenue per visitor going forward.

 This core business of selling buyside leads to real estate agents is what the Company refers to as their Internet Media & Technology (IMT) segment.  Today this business earns ~$1.3B of revenue and ~$285M of EBITDA. The Company’s 3-5 year plan is to grow this business to at least $2B of revenue and to improve EBITDA margins from ~22.5% to ~30% (this compares to margins of ~50% for REA and ~75% for Rightmove).  If the Company can achieve these targets then the IMT division alone would likely support the entirety of Zillow’s current market valuation. As shown below, $600M of EBITDA should translate roughly into $400M of free cash flow or around $1.90 / share which would be a 7.5% FCF yield on the current share price

  What is most exciting about Zillow is that you are effectively getting the entirety of their iBuying initiative for free (or close to it).  Prior to Zillow’s co-founder Rich Barton stepping in as CEO, Zillow had never monetized the sell side of the real estate transaction. Barton who previously founded Expedia and Glassdoor saw an opportunity to change that by replicating the i-Buyer model invented by VC backed companies like OpenDoor and OfferPad.  Despite being a relative late mover in entering the i-Buying space Zillow’s early trajectory has been remarkable and they are fundamentally advantaged over their competitors. Anyone else seeking to profitably acquire and resell homes is going to have significant customer acquisition costs, whereas Zillow given their position as the de facto starting place for 70%+ of US online real estate browsing will be able to leverage the existing traffic to its website to garner demand for this new service for free (or close to it).

 Since its early days Zillow has used its proprietary Zestimate to show consumers what they think over 100M homes in the US are worth.  The Zestimate sits right next to the “get your offer button” that starts a customer down the journey of getting a bid from Zillow’s i-Buying service.  Zillow’s historical experience in calculating Zestimates puts them in a unique position to accurately value homes and select the properties that it thinks has the best chance of being able to re-sell for a profit.  Behind the Zestimate is a tremendous amount of historical transaction data that is unrivaled in the industry. In order to take maximum advantage of that data, Zillow has built an industry leading collection of data scientists.  We believe the combination of the widest selection of potential i-Buying homes to bid on at the lowest cost to acquire and the most sophisticated valuation capabilities should give Zillow the ability to build a profitable business by cherry picking the homes that are the best candidates for purchase and resale at a profit. 

 There is a staggering amount of demand from which Zillow should be able to cherry pick homes for purchase.  While these statistics are somewhat dated they illustrate the tremendous amount of latent demand for Zillow’s i-Buying service and the ability for Zillow to be selective in dealing only with the homes that it feels it can resell for a profit.  Zillow launched their Offers program in Phoenix last May and in the first month after launch received offer requests for 15% of all homes sold in in the area. That increased to 35% by October. Importantly Zillow also has the opportunity to monetize the portion of i-Buying requests that it chooses not to transact on by handing them off as seller leads to their large community of Premier Agents.  You can effectively think of the profits that Zillow can make on these commissions as a negative customer acquisition cost for its i-Buying business. The other i-Buying platforms are unlikely to be able to monetize these leads as effectively as Zillow given Zillow’s existing deep ties into local agency community and its superior data around which agents are best suited to sell which houses.

 The rough unit economics for the seller in an i-Buyer transaction are as follows.  Zillow will typically purchase the house at a single digit discount to fair market value.  This discount should be justified by certainty and speed of close as well as underpinned by the ability of the i-Buyer to cherry pick only the most attractive homes to purchase out of very large number for which it is received bid requests.  Zillow will charge 5-10% service fee which compares to the standard 6% two sided brokerage fee in a traditional transaction in addition to numerous hidden fees associated with selling a home in the traditional fashion. These include potential for pre-marketing renovations, prolonged carry cost on the mortgage during the overlap period with the sellers new home, and potential costs for re-trading by the buyer down the line in the closing process.  At maturity Zillow is targeting a 4-5% return on homes sold before interest and before corporate overhead associated with operating the homes business (right now they are at roughly breakeven). Corporate overhead will cost another 1-2% of the purchase price and interest expense will cost another 90 bps assuming a 4.5% interest rate, 80% LTV, and 90 day hold on the properties. 

 An important point as it relates to corporate overheads is that the business should develop scale advantages in each of the local markets where it operates because Zillow will be able to vertically integrate things like renovation and caretaking across a large base of homes in a way that traditional mom & pop flippers cannot.  They also anticipate taking a data driven approach to deciding which repairs make sense for which house and what those repairs should cost whether they be completed by third party contractors or Zillow’s own first party construction teams

 With a central position in the real estate ecosystem Zillow sees a long term opportunity automate and streamline the many antiquated and arduous elements of the real estate transaction process beyond just being a liquidity provider.  The most obvious and most advanced of these efforts is around mortgage origination. The attach rates and unit economics of public homebuilders provide a reasonable view into what the economics for this business might look like for Zillow.  Homebuilders like Hovanian and DR Horton typically make around $10K per mortgage originated and earn ~30% operating margins. Attach rates are ~60%. That would imply an extra profit opportunity of $1800 per home sold

 How much can Zillow make per i-Buy home?  The following table shows the potential profitability per home purchased

 In 5 years Zillow hopes to be purchasing 5K homes per month or 60K homes per year which would be scratching the surface of the total addressable market for i-Buying services.

  There are ~4.7M single family home sales / year in the US.  Obviously, not all of these would be a good fit for i-Buying.  If we narrow addressable market to those homes in the top 50 MSAs and priced between $250K and $500K the universe is limited to around 1M homes / year and or about $320B of transaction value.  Zillow’s 3-5 year target corresponds to only around 6% of this market providing a long runway of future whitespace to continue to grow. Given the high returns on equity capital, significant barriers to entry, and opportunity for continued growth, the i-Buying business should be worth a premium multiple when it reaches this scale. 

 If Zillow can achieve its targets for both IMT and i-Buying (at mid-point economics) the Company would be generating $1B of EBITDA (net of non-recourse interest expense on the i-Buying warehouse line) in 3-5 years.  This compares to Zillow’s enterprise value today of $7.4B (ex-warehouse lines). If the IMT business were to be worth 15x EBITDA and the i-Buying business were to be worth 20x that would imply a value per share for Zillow of $83 in 3-5 years time and a 17-30% IRR from the current share price without giving any credit for interim cash generation.

 How big can the i-Buying business ultimately be?  If Zillow were to one day capture 25% of the eligible TAM of homes located within the top 50 MSAs with prices between $250-500K, then they would be purchasing 250K homes / year and they’d have the opportunity to generate between $1.3-$2.5B of EBITDA.  Using the same sum of the parts multiples as above that would translate to a share price between $170 and $280

Risks

-        Recent traction on the premier agent program peters out and the Company is unable to achieve its 3-5 year targets for this segment

-        Real estate agencies like Compass and Redfin achieve enough market share to offer a credible top of the funnel discovery alternative to Zillow on their own sites and choose to no longer list their inventories on Zillow

-        Irrational competition from the likes of Softbank-backed OpenDoor make it so that Zillow cannot profitably compete in i-Buying despite their significant advantage in customer acquisition

Catalysts

-        Continued progress against 3-5 year plan – specifically continued operating leverage in IMT, traction with the new Zillow flex program, and continued share gains in i-Buying against OpenDoor / OfferPad

Catalyst

1. Catalysts

   -        Continued progress against 3-5 year plan – specifically continued operating leverage in IMT, traction with the new Zillow flex program, and continued share gains in i-Buying against OpenDoor / OfferPad