ZipRealty brings a unique business model to a very large market, and with it a real opportunity to shake up the status quo in an otherwise mature industry. Zip is an online real estate broker, providing discounted services to property buyers and sellers through its in-house broker-employee base.  Zip is able to charge less than traditional brokerages by avoiding the fixed costs of an office-based brick-and-mortar structure, and through improving broker productivity by supplying brokers with leads instead of having them source their own.  In addition, Zip will be well positioned to benefit as more and more home buyers and sellers utilize the internet to help with their home purchase or sale.  Over time, we also believe Zip may be able to create a sustainable competitive advantage by learning to generate and close online leads at a lower cost than competitors.

 

The company has $88mn of cash, representing 50% of the share price.  The cash is more than just cash; it provides an important strategic asset for a company as disruptive as Zip, particularly at this relatively early stage of development.  Net of the cash and some NOLs, we believe an investor is paying about $70mn for an enterprise currently generating nearly $100mn in sales, with the potential to grow very rapidly.  While the company is operating at around breakeven in what is a very tough real estate environment, we believe the option value of the business model is substantial and worth multiples of the current stock price.  As long as management doesn’t do anything stupid with the cash, our downside should be at least partially protected.  If the business model proves its worth, so will the stock.

 

NOTE: for purposes of this write-up, the word “broker” or “agent” refers to a person, while a “brokerage” or “agency” is a firm.

 

 

 

The Zip model has the potential to be disruptive to the real estate brokerage industry as it attempts to address the following issues:

 

 

In the “2005 National Association of Realtors Profile of Home Buyers and Sellers” published by the National Association of Realtors (NAR) they claimed: “Nine out of 10 home buyers use a real estate agent in the search process, but use of the Internet to search for a home has risen dramatically over time, increasing from only 2 percent of buyers in 1995 to 77 percent in 2005; it was 74 percent in 2004. The next largest source of information for buyers is a yard sign, mentioned by 71 percent of buyers.”  We believe the traditional brokerage model will be coming under pressure as the internet provides better access to information for buyers and sellers.  Human brokers will always be an important part of the process, but their traditional roles will have to become more customer-centric as the industry evolves.  Zip could be at the cutting edge of this transition.

 

Zip’s strategy is unique and very intelligently thought through.  In essence, Zip uses the internet to generate leads for its agents so those agents can focus on customer service rather than business origination.  This is good for the broker, as his productivity improves, and good for the customer, as his service improves.  Unlike most brokerages, which target home sellers in order to build an inventory of properties, Zip targets buyers (who represent over 80% of its business).  The company attracts buyers to the site with a strong value proposition and direct access to databases of MLS home listings that are traditionally accessed by the broker but not the customer.  The kernel of the value proposition is a 20% rebate of Zip’s commission to the buyer, or about $1,800 on a $300,000 home purchase – a meaningful sum to nearly every home buyer.  Although Zip’s focus is on buyers, sellers are also financially encouraged to use ZipAgents, with the company offering a 25% discount to typical broker commissions.

 

The value to property buyers and sellers is clear – discounted prices/rebates and a broker focused on the customer rather than on building his book of business.  But the model does not work unless the broker is compelled to sign on as an employee.  The critical metric around which the model hinges is broker productivity.  Between discounting the price and offering access to better information, the company is able to provide its ZipAgents with what they need most: motivated home buyers.  By supplying the leads to the broker base (who are employees of Zip and work full-time on an exclusive basis), Zip frees up the broker from time- and resource-intensive marketing activities and allows the broker to focus entirely on providing outstanding customer service to buyers.  (Investment managers who have devoted long hours to marketing their funds will understand the value of structuring an entity to permit focus on research and analysis, the true value drivers of the business.) 

 

Having leads provided by the company also makes the ZipAgent much more productive, with experienced ZipAgents (defined as those with more than one year of tenure at the company) averaging over 1.2 closed deals per month vs. 0.5-0.8 for the typical broker.  Although ZipAgents are paid on a commission of 35-80% (depending mostly on productivity), which is somewhat below the industry average of 70-80%, Zip covers brokers’ operating and customer acquisition costs, which are traditionally borne by the agent, and offers a benefits package.  Benefits are an important point of difference from most traditional brokerages, which utilize agents on an independent contractor basis rather than as direct employees and therefore don’t provide benefits.  Conversations with a number of current and former ZipAgents in various regional markets returned a consistent message providing evidence that the model is working. ZipAgents regularly expressed their happiness with operating in a team environment and being able to offer better customer service instead of having to worry about tracking down the next lead.

 

Zip’s cost structure has a large variable component.  If managed correctly, the business needs almost no capital to operate and minimal capital to grow.  Costs include broker commissions, online lead generation, some broker operating costs, regional management, IT, software development, and basic corporate overhead. 

 

Leads are essentially a variable cost assuming constant broker productivity – the company pays on average about $1,000 per successful online lead.  This number has been relatively consistent for the two years for which we have quarterly data, though we might begin to see it trend down as the company generates more and more traffic directly to its site (what amount to essentially “free” leads through word-of-mouth marketing and other means).  The commissions the company pays to its ZipAgents are also completely variable, based entirely on sales performance.  Regional management is variable by market but fixed within a market, while IT, software development and corporate overhead are largely fixed, though at what level is somewhat at the discretion of management.  Zip avoids the investment and fixed costs associated with maintaining brokerage offices as it typically does not house its ZipAgents (who work from home or from premises they maintain on their own).  As such, Zip’s total fixed commitment for real estate over then next 5 years is only $5.8mn.  Also, there is no bad debt risk and working capital is favorable: "Our primary source of operating cash flow is the collection of our commission income from escrow companies or similar intermediaries in the real estate transaction closing process.  Due to the structure of our commission arrangements, our accounts receivable are converted to cash on a short-term basis and our accounts receivable balances at period end have historically been significantly less than one month's net revenues” (from the 10K).

 

The unit economics reveal the potential competitive advantage inherent in Zip’s model.  There are two pieces to the analysis that matter most: (1) does Zip have a comparative advantage over traditional brokerages, and will they be able to have a competitive advantage over copycat models?, and (2) do brokers do better or at least as well with Zip as they would with a traditional brokerage?  We put together much of the analysis below through scuttlebutt research, so we would caution that the results should be viewed merely as indicative of an underlying truth rather than as conclusive.

 

Taking the first question first, illustrative economics of a single “side” of a transaction (a purchase or sale of a home) for Zip are as follows:

 

Commission rate per side:

2.75% less 20% rebate to buyer = 2.20%

Average commission revenue:

$325k average home price x 2.20% commission rate = $7,150

ZipAgent commission plus benefits and reimbursed expenses:

55% of $7,150 fee = $3,900

            Variable contribution:

                        $7,150 fee - $3,900 ZipAgent comp = $3,250

            Cost of leads:

                        $1,000 per closed side

            Net contribution:

                        $3,250 variable contribution – $1,000 cost of leads = $2,250

 

In the fundamental business transaction, Zip makes over two times its money off of a $1,000 “investment” in leads.  Zip must use this $2,250 contribution to cover its overheads, which consist of regional management, IT, software development, and basic corporate overhead.

 

Looking at the illustrative economics of a single side for a traditional brokerage:

 

            Commission rate per side:

2.75%

Average commission revenue (home price set equal to Zip’s for comparability):

$325k average home price x 2.75% commission rate = $8,950

Broker commission:

75% of $8,950 fee = $6,700

            Variable contribution:

                        $8,950 fee - $6,700 broker commission = $2,250

            Cost of leads:

                        $0 (borne by the broker, either directly or as a charge-through)

            Net contribution:

                        $2,250 variable contribution – $0 cost of leads = $2,250

 

A traditional brokerage must use this $2,250 contribution to cover its overheads, which consist of office rent, regional management, IT and basic corporate overhead. 

 

So Zip and the traditional brokerage would appear to earn a substantially identical net contribution per transaction.  As a traditional brokerage has a greater fixed cost infrastructure (mostly the result of its agency office leases), however, Zip can generate what ought to be a sustainable comparative cost advantage over traditional agencies. 

 

If Zip indeed has an advantage over traditional brokers, the key to its advantage is maintaining a low cost of leads.  The low cost of leads might stem from two key points: (1) ZipAgents’ ability to convert leads at higher relative rates, and (2) Zip’s ability to generate or buy leads at a lower relative overall cost.  On the first item, ZipAgents can achieve better conversion of leads because the model frees them up to devote all of their time to converting, rather than having to spend what for most brokers is the majority of their time on generating leads.  Further, Zip’s excellent systems and processes coupled with its proprietary training methods could give ZipAgents an edge over their traditional broker brethren.  On the second item, Zip may be able to generate or buy leads at a lower relative overall cost because it can leverage its scale as a purchaser of leads across multiple markets (becoming increasingly national), whereas local brokerages and at least some of the larger traditional brokerages push down the purchase of leads to the broker level and therefore do not leverage any scale.  As important, Zip is increasingly generating traffic on its sites “for free.” This occurs through the combination of (1) word-of-mouth advertising, which benefits from a positive feedback mechanism and has the possibility of reaching a tipping point, (2) natural search through Google and other search engines, and (3) Zip-managed local content-only websites, which direct interested parties to Zip’s main site.  As these trends continue, Zip ought to be able to generate leads at a lower and lower average cost per lead.  If Zip is able to maintain its “learning curve” on broker conversion/productivity, leverage its scale in purchasing leads, and generate more “free” traffic through the viral effects of word-of-mouth advertising and the network effects of natural search, the company may be able to create a sustainable competitive advantage not just against traditional brokerages, but against up-start copycat brokerages as well.

 

Looking at the economics from the broker’s perspective is equally important and revealing.  A ZipAgent with one year of experience would see the following economics:

 

            Commission rate per side:

2.75% less 20% rebate to buyer = 2.20%

Average commission revenue per side:

$325k average home price x 2.20% commission rate = $7,150

ZipAgent commission plus benefits and reimbursed expenses per side:

55% of $7,150 fee = $3,900

            Transactions closed per month:

                        1.20

            Transactions closed per year:

                        1.20 transactions closed per month x 12 months = 14.4

Net ZipAgent annual compensation:

14.4 transactions closed per year x $3,900 commissions, benefits and reimbursed expenses per side = $56,600

 

The traditional broker would see the following economics:

 

            Commission rate per side:

2.75%

Average commission revenue per side (home price set equal to Zip’s for comparability):

$325k average home price x 2.75% commission rate = $8,950

Broker commission per side:

75% of $8,950 fee = $6,700

            Transactions closed per month:

                        0.70

            Transactions closed per year:

                        0.70 transactions closed per month x 12 months = 8.4

Broker commission per year:

8.4 transactions closed per year x $6,700 commissions, benefits and reimbursed expenses per side = $56,300

            Cost of leads per closed side (assumes same total cost of leads as paid by Zip):

                        $1,700

            Cost of leads per year:

Cost of leads per closed side of $1,700 x 8.4 transactions closed per year = $14,400

            Other operating costs and expenses (desks fees, computers, etc.) per year:

                        $10,000

Net broker annual compensation:

$56,300 broker commissions – cost of leads of $14,400 – other operating costs and expenses of $10,000 = $31,900

 

Once all of the costs are figured in, it is clear that the ZipAgent is going to be happier with the economics than the traditional broker.  As long as Zip’s $1,000 cost of leads per closed side holds, the ZipAgent will be at least indifferent to Zip or another agency at productivity levels of around 0.80 closed sides per month or greater.  When one considers the qualitative benefits of being a ZipAgent, like avoiding the hassles of lead generation, working in a more team-oriented and entrepreneurial culture and having excellent systems and processes to support one’s operations, the broker’s decision becomes even more self-evident.

 

The business in general requires very little capital outside of what are already low start-up costs as nearly all of the costs of the business are related to commissions, lead generation and upkeep of technology.  New markets require a fixed cost of about $500k, representing 4-5 personnel and a small non-customer-facing office, with an 18-month expected ramp to profitability.  For instance, Las Vegas contributes $600k in profit on $300k in fixed cost “investment” and Houston and Miami turned a profit after less than a year on $500k in fixed cost “investment” in each market (where “investment” refers to cumulative operating losses generated prior to breaking even). 

 

 

 

The real estate brokerage market in the U.S. is very large, with commissions totaling an estimated $66bn in 2005.   Zip is not even a speck on the horizon at this point, leaving lots of room to grow share.  Zip is currently operating in only 20 markets (15 of the top 25), with nearly 40% of its business in CA alone.  As the model is internet-based and easily scaleable, Zip can readily enter many more of the 250 U.S. MSAs.  Although competition is fierce in residential brokerage, the large traditional competitors are unlikely to put their franchises at risk in an effort to match Zip on price (particularly what will now be the highly-leveraged Realogy, following the pending acquisition by Apollo).  While Zip’s model is conceivably replicable, Zip has at least a seven-year lead on most of the competition, which may prove difficult for an upstart to surmount, particularly as Zip continues to establish its brand and cost advantage within its regional markets.

 

Zip also has a largely untapped opportunity to sell ancillary products to its customer base.  Given the close relationship with the home buyer and seller and the event-specific needs of those customers, it is common for brokerages to generate significant revenues and income from the sale of products such as mortgages leads, home and other insurance, surveying, valuation, legal, escrow and title work, moving, etc.  Zip has only begun to scratch the surface of this opportunity.  Furthermore, Zip’s business has built-in price increases as commissions are generated off the price of a home, which tends to rise over time at the rate of inflation or better (although admittedly that is unlikely to happen in the near-term).

 

 

 

Management seems to have taken an appropriately careful stance in the current environment and significantly reduced guidance in Q2, projecting operating losses for the year.  The projected losses will keep away short-term investors unwilling to look further out to what ought to be strong profitability in a more normal environment.  In Q3, sales of existing homes fell 14% year-over-year nationally and 32% in CA, Zip’s largest market by far.   In Zip’s markets overall, volume was off 25% in Q3 vs. prior year, having been down 15% in Q2 and 10% in Q1.  In CA, the rate of decline was 35%.  Management attributes the tough environment to tentative buyers making fewer offers, despite increased demand (traffic).  Average inventories in Zip’s markets were up 89% in Q3 after having been up 100% in Q2, with months of inventory up from 5 in Q2 to 6.5 in Q3.  Registration volume was up 14% year-over-year in Q2 and scheduled buyer visits were up 50%, but offers were down 3%.  Buyers are also looking at 50% more homes before putting in an offer and 36% of listings had reduced prices in Q2.  Furthermore, Zip gained market share in all of its markets in Q3 in terms of transactions, including CA (33% decline for Zip vs. 35% for the market).  Outside of CA, Zip’s transactions declined 5% in Q3 vs. 20% for the comparable market.  When the market does normalize, the operating leverage inherent in the business should become more obvious. 

 

Zip came public in 11/04 and opened at $17.00 per share, trading as high as $19.70 before cracking.  The current price is less than half the IPO price, meaning there are a lot of disappointed investors.  Zip is easily bucketed into out-of-favor industries (the “internet” and “housing” sectors) and as a small cap company with a dismal stock price chart, limited liquidity, potentially large mark-to-market risk through the industry downturn and an unproven model, it is likely off the radar screen for many investors.

 

 

 

CEO Richard Sommer was appointed in August 2006, having previously run HomeGain (Zip’s largest source of online leads) and having held senior positions at IndyMac, Move.com and Realtor.com.  He also founded and sold a healthcare business.  Sommer is an exceedingly intelligent individual (he is a Rhodes Scholar, Stanford Law graduate and Princeton undergraduate) and has a commanding physical and verbal presence.  Although he has not yet stated his own vision for the company, our personal diligence leads us to believe he will be a strong leader for Zip.  Sommer’s relationship with HomeGain helps to mitigate the risk Zip has in using HomeGain to generate 29% of its online leads (see risks below).

 

On 12/14, Zip’s CFO Gary Beasley resigned.  We were not surprised by this outcome.  Beasley had spent the last five years of his life building this business and was essentially passed over for the top job when the Board brought on Sommer.  We view Beasley’s departure as part of a “cleaning house” under the new CEO.  Although Beasley was a strong manager and his departure is a true loss for the company, if Sommer is to achieve his own vision for Zip he needs full alignment with his team. 

 

Management has a long-term focus and is extremely process-oriented and data-driven.  The Zip technology platform records all sorts of information, including customer logon frequency and times, specific homes viewed and printed, searches made by clients, requested visits to view a home and online offers, as well as frequency and length of ZipAgent logins, copies and organization of ZipAgent emails and mandated logs of client phone calls, visits conducted and offers submitted and accepted.  The company uses automated closing checklists to allow ZipAgents to efficiently handle the closing of multiple transactions.  When seen up-close the systems are very impressive.

 

 

 

Most of Zip’s stock is closely held by the original venture capital backers (Benchmark Capital, Pyramid Technology Ventures and Vanguard Ventures) and a handful of value-based funds (Springhouse, Steadfast, ourselves).  The VCs effectively control the Board and will hopefully ensure that the company does not squander its excess cash balance.  The new CEO Richard Sommer was granted 1.25mn options (over 4% fully diluted) at a little over $6 per share. 

 

 

 

We think of Zip’s valuation as option value plus cash.  The company did make a profit in 2005, generating EBIT of $4mn on sales of $93mn.  However, 2005 was an unusually strong year in the housing market and we would be careful not to rely on those results as indicative of underlying earnings power.  It is comforting that the company has shown it can generate a profit, but future earnings power truly will hinge on Zip’s ability to attract new customers and maintain broker productivity and a low cost of leads while continuing to enter new markets that meet its return on investment objectives.  It does not take heroic assumptions on profitability or growth to justify the $70mn price tag for the enterprise implied at today’s prices.  The cash balance provides a cushion of around 50% of the share price.  Zip’s unique business model and growing brand equity could certainly allow it to take a 1 or 2% share in its existing markets, if not more, which would imply a business value of significantly greater than $70mn.  If Zip is able to achieve the competitive advantages in lead generation and broker productivity for which we outlined the potential above, intrinsic value would be even greater.

 

 

 

The primary risks are as follows:

 

-         The company attracts price competition, either from incumbents like Realogy or from other internet-based start-ups like RedFin

-         Existing home sales, which from 2003-2005 ran very hot and is the primary macroeconomic driver of Zip’s business, continue to fall sharply and steady out at unusually low levels for several years, making it difficult for Zip to turn the corner on profitability.  Zip’s regional exposure to the “boom-ier” CA market in particular could exacerbate this issue

-         NAR and other traditional realtors find a way to effectively block Zip’s access to MLS databases (the DoJ so far has not allowed this to occur on what seem to be solid grounds of anti-competitiveness)

-         Lead generation becomes more expensive or high quality leads become more difficult to obtain.  HomeGain takes advantage of its position as the main supplier of leads to Zip (representing 29% of Zip’s online lead generation in 2005; Google was 12%)

-         New CEO has not yet outlined his strategy for the business