Summary

• Zillow, Redfin, and Opendoor are all looking to improve the archaic buying experience in real estate through iBuying and offering adjacent products

• Zillow’s primary strength lies in its ownership of the customer relationship, which will translate into lower customer acquisition cost on both the buying and the selling of homes

• The unit economics remain unproven but Zillow has outlined a path to 2-3% adj. EBITDA margins. If successful, Zillow could more than double its adj. EBITDA

• Zillow’s most significant risk in the near-term is the large amount of change underway at both its new and core businesses. These changes, and the resulting guidance revisions that could come, have weighed on the stock

Zillow sits at a transformational moment in its history. Historically an ad business that connected buyers to agents, Zillow is in the early innings of a pivot to a one-stop shop for real estate. This pivot involves getting into the nascent iBuyer industry, a controversial business model that could either upend the real estate industry or blow up, as well as making significant changes to its existing ad business. Zillow is also building ancillary businesses in mortgages, title insurance, and other adjacencies.

As many have noted, these changes all present a significant amount of risk in the near-term for the business. A look at recent performance hints at this, with Zillow stock down over 40% since 2Q19 earnings.

At the same time, it's also potentially a huge opportunity. Zillow and numerous other real estate companies are racing toward the finish line - an all-digital, seamless home purchasing experience. And while now might not present the best entrance given a rocky near-term outlook, I believe Zillow is well-positioned to succeed in this industry longer-term.

The Finish Line - A Seamless Buying Experience

It’s helpful to first take a step back and look at how the buying experience in other industries has radically changed with the advent of the internet. Amazon made the purchasing process so seamless that a shopper can now find a toilet, order it with a click, and have it at his/her doorstep in two days. Similar experiences can be seen in buying a car (Tesla, Carvana), ordering takeout (Grubhub, DoorDash), meeting someone (Tinder), and getting somewhere (Uber, Lyft). Customers have been trained to open an app and press a button to get what they want.

Buying a home is one of the few areas today that has not moved in that direction. While companies like Zillow have made it easier to find home listings and get more information about it, you’re immediately moved away from Zillow and into the old-school real estate world once you’re ready to see it in person. The process then involves painful home tours, negotiations on price and potential repairs, inspections, paperwork, title insurance, more paperwork, and escrow. And at the end, the buyer and seller each pay a hefty 3% to brokers for their help in the process.

Numerous real estate companies are now racing to streamline and digitize the home buying process. The three companies I’ll focus my discussion on here are Zillow, Redfin, and OpenDoor, but note that there are other iBuyers and real estate brokerages that are focused on this problem as well. The approach to take on more of a customer’s pain points can be seen in Redfin CEO Glenn Kelman’s comments from their 4Q18 conference call (emphasis mine):

One of the challenges in improving homebuyer's success rate is that there are so many reasons outside of the homebuying process itself that customers decide not to buy a home: because they can't sell the old one or they can't get a loan or because the closing gets hung up. We've come to recognize all of those problems as Redfin's problems. With one new Redfin service rolling out after another for fixing up homes with Redfin Concierge Service and buying them on the spot with RedfinNow, for lending money through Redfin Mortgage and handling the closings through Title Forward, our 2019 strategy is to take responsibility for every part of a customer's move. Our customers need this from us and in delivering it, we can grow revenues faster than our customer base.

Zillow’s Competitors Are Positioned Well but Lack Customer Awareness

Each company is starting at a different point in the home buying process, which naturally creates both opportunities and weaknesses relative to their competitors.

Redfin. Redfin is a broker that uses technology to lower the cost of using an agent to buy or sell a home. Because their agents are 3x more productive than the average agent (due to the help they get from technology), and are salaried employees rather than independent contractors paid on commission, Redfin is able to charge 1% to 1.5% to the home seller compared to the 2.5% to 3% that is typically charged. This presents a compelling value proposition to a seller as they save thousands more by going with a Redfin agent. For buyers, Redfin offers savings as well as a superior buying experience with on-demand tour scheduling and more data to inform bids.

As an agent, Redfin already has a hand in many real estate transactions without any of the inventory risk that an iBuyer might have. In 2Q19, Redfin was involved in almost 19,000 real estate transactions, representing almost $9 billion in gross real estate dollars, and almost 1% of the total market. This is less than other larger real estate brokers, but the larger brokers are not using tech to the same degree to increase broker productivity. It’s also much higher than the number of transactions Opendoor or Zillow directly touch. Given how close Redfin is to the transaction, they are also expanding into adjacent products like mortgages and title insurance to offer a more streamlined purchasing process (as highlighted in the CEO’s comments above).

With a value proposition focused on cost, Redfin has spent much of its resources bringing down broker fees with various products. For example, the company offers Redfin Direct, a tool that helps buyers make an offer on a home without a broker or a broker fee. Additionally, Redfin has automated home tour scheduling, which speeds up the time a consumer can see a home and reduces broker time spent emailing with clients. Redfin still largely uses brokers to help close on homes, but their offerings make it clear that the company is aiming to reduce the friction in buying a home with an eventual goal of all-digital home closings.

It should also be noted that Redfin is involved in iBuying with Redfin Now, but the scope and scale of the program is much smaller than the other iBuyers. In fact, CEO Glenn Kelman has noted some skepticism around the unproven economics of the model:

And I just wanted to talk about my attitude or our attitude toward iBuying. As we tried to make clear over the past 6 months, the demand is real and it's very strong. So we are quite committed to this business, but anyone in this business should be scared. And if they aren't scared, you should be scared because we are taking significant capital risk and most of the folks in the space are losing tons of money and you have to have a clear path to profit. So you have to know exactly how scale is going to let you renovate homes more efficiently. You have to know exactly how you're going to be able to market those homes directly to the buyer. And it's hard to pull apart because when you're growing really fast, you're paying forward some of your growth and that limits your margins, but you're also trying to get more efficient. And whenever you're going to get more efficient and grow at the same time, it's just a real challenge. And so we're just trying to be eyes wide open about those risks, and I think that's the way you would want us to be.

With that said, Redfin is not ignoring the iBuying business - just being extra cautious. Redfin currently has a partnership with Opendoor in place where they hand over demand that they cannot fill. Additionally, Redfin is looking to grow Redfin Now more rapidly going forward. The company expect $70M from Redfin Now in 3Q alone vs. the $60M that they generated in the first half of the year.

While their strength is in their proximity to the transaction, they are weaker at the top of the sales funnel where there is less awareness of Redfin. The company’s 37 million unique visitors per month is nothing to sneeze at, but it’s small compared to Zillow’s roughly 200 million monthly unique visitors. For this reason, one of Redfin’s primary initiatives recently has to been to raise awareness of the company by increasing its marketing spend. Redfin is expected to grow marketing spend from $44M in 2018 to $81M this year in an effort to educate more people about Redfin. The effectiveness of the marketing spend, and the amount of time until the benefits are seen, are key debates for the stock currently among institutional investors.

Note Redfin’s weakness is not just in awareness, but also in conveying a more complex message. While one would think that generating $12,000 in savings for each sellers is a simple message to convey to consumers, it can be made more difficult due to the fact that many consumers are not even aware that brokers will charge a listing and buyer fee.

Additionally, Redfin must balance sending a conflicting message as both an iBuyer (albeit a small one currently) and an agent. When a seller comes to Redfin for an iBuyer quote, they will likely get a conservatively priced quote on their home. If the seller chooses not to accept Redfin’s offer (presumably because the offer is too low), then Redfin must still convince the seller to use them as their broker, even though they priced the home at a lower rate than what the owner thinks it’s worth.

Lastly, there are some questions around Redfin’s moat. The company relies on technology and local expertise with its salaried brokers. At some point, you have to imagine that Zillow and Opendoor will compete more directly with Redfin by aiming to eliminate brokers as well. And while each market brings unique nuances and legal challenges, it seems like a solvable issue for a well-capitalized real estate company.

If you believe that iBuying might not work out to be a profitable business, Redfin might not be a bad business to invest in given that they are entering the space more cautiously, but still looking to change the customer buying experience with a more seamless agent experience. The company currently offers full digital closings in several markets, and will continue to work to make it more seamless and available in more markets.

Opendoor. Started in 2014, Opendoor was the first company to begin the iBuying category. Today, the company is the largest iBuyer on the market with about 11,000 homes bought and 7,000 homes sold in 2018. The company aims to execute over 30,000 transactions in total for 2019.

As the largest and longest standing iBuyer, the company is probably the furthest along in proving the economics in the iBuyer business model. Opendoor began in Phoenix and Dallas, where homes are relatively standardized and easy to value. The company charges a 6-13% fee (when buying the home), performs renovations, and quickly prepares the home to be sold, aiming to hold the home for 90 days or less. Zillow and other iBuyers have largely followed these moves and have similar objectives.

Opendoor also allows potential home buyers to tour a home without an agent present. This is a double-edged sword. On the one hand, it significantly reduces one of the most expensive parts of selling a home - the touring. Agents can easily spend an entire day showing potential buyers homes without any guarantee that the potential buyer will move further with a home. Redfin has called this out as a particularly difficult part of the buying process, as they have noted that buyers have become increasingly casual about seeing a home. By allowing consumers to tour a home without an agent present, Opendoor bypasses these issues and allows for a greater volume of potential buyers to see a home. On the other hand, Opendoor’s policy also has presented PR issues where potential buyers have found squatters and drug users in the homes. While the actual prevalence of these issues is unknown, it does harm the reputation of the company and the customer experience.

Like Redfin and Zillow, Opendoor has also recognized the importance of offering a complete solution. In recent months, the company has acquired/launched a mortgage, title, and escrow business.

While Opendoor’s strength is in its iBuying from sellers, they likely spend more on finding buyers than Zillow or Redfin, since OpenDoor doesn’t have the same level of traffic and customer awareness as Zillow does. Additionally, their ability to price each home accurately is going to be crucial given the volumes that they are buying and selling the homes, and I wonder whether they will be able to do so given that they don’t have access to as much data as Redfin or Zillow.

Zillow’s Entrance into iBuying Expands its Opportunities

Before getting into Zillow’s strategic advantages in iBuying, we should first talk about why Zillow has decided to move into the space.

The best strategic article that I would recommend reading is Stratechery's views on Zillow and OpenDoor. Ben's articles on Opendoor actually influenced Zillow's decision to move into the iBuying industry. In sum, the article discusses Zillow's place as an aggregator of sorts, akin to other powerful aggregators like Facebook, Netflix, or AirBnB. However, up to this point, it had served as a weaker version of one. Zillow serves ads for agents that help facilitate the transaction, but they are completely removed from the transaction. This has limited Zillow's ability to change the industry, and up to this point, has largely limited Zillow's total addressable market as well.

Indeed, Zillow's PA business had also begun to slow, and questions were beginning to arise around its long-term growth trajectory. I'll discuss this in more detail later.

This was likely one impetus for Zillow to move into iBuying last year, which has been detailed numerous places elsewhere. In short, Zillow is getting into the business of buying and selling homes. This move allows Zillow to get involved in the transaction itself and actually disrupt the real estate industry, as opposed to simply facilitating the connection of buyers to brokers.

The surface level reaction to this has been largely negative. This move means that Zillow will transition from a capital-light, high margin business to a capital-intensive, low margin business. Zillow will hold the inventory risk at a time when the housing market is showing signs of slowing, and 10 years after the last recession.

But it's important to note that there is a huge amount of upside as well. By getting closer to the transaction, Zillow drastically increases its revenue opportunities. There’s an estimated $1.8 trillion in home transactions each year compared to the $17 billion tied to home advertising (their core business).

Numerous other companies have made similar transitions in their own ways. For example, Yelp has been in a multi-year attempt to move closer to the transaction as opposed to simply serving ads on behalf of local businesses at the top of the funnel.

This is a particularly good example as Yelp has struggled to move down funnel where they have met stronger competition from the likes of Grubhub, Doordash, Opentable, and others. These companies have integrated other aspects of the business to provide a better customer experience than Yelp. Yelp has been largely confined to the top of the funnel as a result.

The key here is whether Zillow can flex its power as the starting point for buyers looking for a home. With >200M unique visitors per month on their site, Zillow is now known as the Google for real estate, and the starting point for a customer’s home buying journey. Can Zillow better serve these visitors as they get closer to the transaction, or are competitors like Redfin, a tech-enabled broker, or OpenDoor, an iBuyer-focused company, better positioned?

Zillow Sees a Path to Positive Unit Economics

Let’s start first with Zillow’s iBuying approach. Potential sellers go onto Zillow and request a quote for their home. A Zillow employee then contacts the seller and gets information and photos about the home. This information is then used by Zillow, along with a local real estate agent performing a market analysis, to then come up with an offer for the home. Zillow then presents this offer, the market analysis, and other instant offers from third parties, to the seller within a few days. While the average fee that Zillow charges is 7%, the fee can vary from 6% to 9%, depending on how quickly they believe they can sell the home. While seemingly expensive, note that sellers currently pay about 6% (or more, if you include other fees) to brokers when selling their home.

If the seller selects Zillow’s offer, they sign a letter of intent and Zillow sends an inspector to the home to perform a more detailed analysis. The price is adjusted based on what the inspector finds, and the home moves towards closing. Once closed, Zillow will perform any necessary renovations and prepare the market for resale on its own platform and other websites. The goal is to hold the home for less than 90 days.

Management hopes that the unit economics of each transaction begins to scale with time. In the near-term, they’ve stated that they hope to break even on the sale of each home, but that over time, they expect to achieve a 4-5% return on homes before interest expense and corp. overhead, and a 2-3% adj. EBITDA margin after stripping out corporate overhead. As the image below highlights, management sees upside to returns from a variety of sources, including scale efficiencies and shorter holding periods (for the return before corp. overhead) and adjacent cross-selling opportunities in title & escrow, insurance, mortgages, and other streams (for the return after corp. overhead).

Note that what Zillow is doing here is not necessary flipping homes as many people think of it. Zillow is not looking to make major renovations and profit significantly on price appreciation (although this is one component of the expected profit). The key here is volumes - Zillow wants to hold the homes for shorter time periods and cross-sell more products and services to buyers. To succeed, Zillow will have to:

• Tweak their algorithm and work with agents to offer a roughly accurate price at the first seller request for an offer

• Work with inspectors to quickly and accurately assess whether a home will need more renovations

• Work with agents to adjust the price appropriately based on new information from the inspector.

• Work with sellers to get the home to close quickly while preserving the iBuyer value proposition to sellers

• Work with many contractors throughout the country to renovate the home

• Work with the listing agent to get it back on the market and sell it quickly

• Build the tools and automation necessary to scale each step

It’s sometimes difficult to frame the IT risk of building new, complex technological tools. But note that the timeline for Zillow’s mortgage business was just recently pushed back as it was taking longer than expected to build the systems out.

As investors have been quick to note, and management readily admits, Homes is a high volume, low margin business. But the quick math on management’s targets would suggest a $400M adj. EBITDA opportunity (on $20B in annual sales and a 2% adj. EBITDA margin) before giving them credit for potential sources of upside. For context, Zillow reported $200M of adj. EBITDA in 2018. If Zillow succeeds, they would more than double the size of their profits.

In my opinion, Zillow looks well-positioned on paper to execute on this complex business. With its industry-leading traffic and customer awareness, Zillow should have very low customer acquisition costs on both the purchase and the sale of each home, especially compared to competitors that struggle at the top of the funnel. They should also be well-positioned to cross-sell customers onto adjacent businesses for similar reasons.

Additionally, Zillow has access to a treasure trove of data on each real estate property. In theory, Zillow can use this data to price homes better than competitors and to stay ahead of a potential housing downturn.

How successful has Zillow been so far? From a volume perspective, the company has moved much more rapidly down funnel than the street’s expectations. The company has bought and sold much more in volume than the street has expected essentially since the segment began. Last quarter for example, Zillow bought 1,535 homes and sold 786 compared to expectations of 1,178 and 772, respectively. And the street expects growth to continue in 3Q and 4Q.

In terms of economics, the company has been roughly on pace and moving in the right direction. Today, the return on homes is -2% to 2% compared to the 4-5% goal that they have at scale. And in terms of overall operating margins, inclusive of corporate overhead, their adj. EBITDA margin is currently at -23%. As would be expected, this is a ways away from profitability as the company is still investing in the infrastructure without any of the scale that they hope to ultimately achieve. However, it is moving in the right direction from prior quarters.

This is an exciting strategy for the company, and as they continue to build out this business, Zillow will likely find more ways to monetize the business and add value to the ecosystem. As the starting point for people looking to buy or sell a home, Zillow owns the customer relationship, which gives them a variety of advantages as they scale their iBuyer business. However, those with advantages on paper do not always win out. Zillow will need to execute and find enough areas to scale and generate margin.

In this regard, management is well-received by the street and appears to be the right people at the helm to lead this shift. Rich Barton recently returned to lead Zillow as CEO earlier this year; he previously served as Zillow CEO from 2005 to 2010. Mr. Barton has also been extensively involved in other marketplaces - he founded Expedia and Glassdoor, served as a partner at Benchmark (a VC that has invested in numerous successful marketplaces), and served on the board of Netflix. The Homes segment is headed by Arik Prawer, a former Chief Integration Officer at Invitation Homes (the largest single-family rental REIT in the US).

With Large Upside Comes Large Downside

There are a few risks that are often raised as Zillow aims to upend the industry.

Too many balls in the air. In my mind, this represents the largest risk to the story, and explains the recent stock weakness. As if entering an entirely new, unproven business model is not enough, Zillow is also undergoing two significant changes in its core Premier Agent business.

For background, Zillow’s core business up to this point has been as an ad platform. Zillow serves broker ads to site visitors interested in properties. Brokers were charged an upfront fee in exchange for buyer leads.

More recently, over the last year or so, Zillow has introduced a new model for advertisers called PA4. As I had previously highlighted, the top of the funnel in real estate is a costly area as brokers spend a significant amount of time servicing clients that could back out of the buying process for any number of reasons. Zillow’s PA4 was meant to help make the top of the funnel more efficient with two changes. First, potential buyers were screened in order to ensure that only customers that were closer to being ready to purchase are connected to brokers. Second, Zillow only put these customers in touch with a broker that answered their phone (note that this was based off feedback that about half of customers were directed to brokers that did not pick up their phone). In theory, these moves made sense and would improve the experience for both buyers and agents.

In practice, agents were largely unhappy with the changes and moved away from the platform. The increased buyer screening led to fewer leads for agents. While these leads were higher quality, agents felt as if the value was not there, as agents were paying the same amount and only getting 4 leads, as opposed to the 8 previously. Additionally, agents wanted both the high quality, low quantity leads, as well as the low quality, high quantity leads. Agents had been trained to nurture these relationships and develop them over time so that when they were ready to buy a home, the agent would be top of mind. In response, the company put into place PA4.1, which made some tweaks to give agents a mixture of the high quality, low quantity leads, as well as the low quality, high quantity leads. While the segment performance hasn’t exactly shined (see performance up to 2Q19 in the PA chart below), management has noted that advertising churn has begun to stabilize, and that feedback has improved.

Just as PA4.1 was beginning to stabilize results, Zillow recently announced another major change to its advertising model with the expansion of Flex pricing during its 2Q19 earnings. This was the primary reason for the large stock drop. Flex pricing is a new mechanism that Zillow has been testing for some time. Rather than charging an upfront fee to brokers, flex pricing charges brokers only if a lead converts into a successful home purchase. This aligns Zillow’s incentives to match those of the customers, and moves the company closer to the transaction. Zillow also receives better economics per transaction (more revenue), according to Zillow’s tests, and it likely expands their addressable market as well given that brokers no longer have an ROI hurdle rate to consider before buying ads.

The company announced that it would expand the test into 2 additional markets in 4Q to increase their learnings about the new pricing model. But as the program expands to additional markets, Zillow will also have to lower their revenue guidance. The reason is that the shift to Flex from an upfront fee is essentially moving revenue normally recognized from the start of a customer’s sales cycle (roughly six months in length) to the back of it. As a result, if Zillow continues to expand Flex, the company will likely have to continue to lower revenue guidance, as they did during their 2Q19 earnings. Consensus estimates currently do not model higher growth until 1Q2020.

The key to Flex’s success is the conversion rate and the pricing. There is a conversion rate where Flex breaks even with the more traditional pricing model. An optimistic investor might imagine that management would not ultimately expand Flex more broadly until the economics work and the margin for error is significant enough.

Ultimately, PA4.1 and Flex 1) creates near-term risk as the company works through any unexpected kinks, 2) diverts senior management focus and attention away from the Homes segment during its crucial ramp years, and 3) pushes more revenue into outer years, further increasing risk from an investor perspective. This was the primary reason that led me to sell my shares in Zillow. However, I do believe that they were the right longer-term moves for the company, and that Zillow will come out a stronger competitor from these decisions.

Economic expansion, and housing gains are long in the tooth. The obvious risk is that now that Zillow is taking ownership of homes on their balance sheet, they could potentially be stuck with depreciating inventory if the market moves in the opposite direction. This is certainly a risk now that we are over 10 years removed from the last recession, and with housing prices up significantly from the bottom of the crash.

However, there are two counterarguments to consider:

• While becoming a market maker is a new phenomenon in the real estate industry, it is not in other industries, like financial markets. Market makers can and have survived downturns by pricing appropriately. Zillow’s ability to survive in such a scenario will require them to see the downturn occurring and to adjust pricing adequately for providing liquidity to the market. With the data that they have, they potentially have the pieces in place to succeed, barring a more severe crash.

• With low housing affordability, it’s tough to see price gains continuing in the medium-term. At the same time, low inventory also likely provides some floor on pricing declines as well. Without more inventory, it’s difficult to see pricing dropping significantly.

Unproven business model. iBuying is significantly more prevalent today, but it still remains early days for the business model. Some challenges have surfaced, including dealing with renovations at scale, and navigating the top of the funnel in a cost efficient manner. It could be the case that iBuying may take longer to achieve profitability (i.e. 10 years), or it could just not be possible if consumers are not willing to give up tens of thousands of dollars in exchange for the convenience of going with an iBuyer. The model will also really be tested when the market takes a more serious downturn. The answer to this risk will be fleshed out over time as the industry matures and as Zillow gets closer to scale.

Conclusion - Near-Term Outlook Hazy, but Longer-Term is Positive

This is a potentially disruptive company at a very early, early stage in its evolution. Its core business is undergoing two major shifts, the home business is not expected to reach scale for several more years, and the unit economics are not yet proven. Additionally, macro risks are heightened and Zillow also faces several near-term headwinds as they expand Flex.

At the same time, Zillow management believes they have a path to profitable economics and several key strategic assets to make this work out. Namely, its ownership of the customer relationship is a huge advantage over competitors, and other marketplaces have historically done well in this position.

My own view is that the near-term picture has enough downside risk to where I don’t think this is good timing to get involved in the story. However, I like the longer-term story, and I believe there’s a high chance that Zillow comes out on top over time.

With that in mind, there’s three things I’d watch for before getting involved in the stock: 1) The numerous changes in PA stabilize and growth reaccelerates, 2) Homes transaction volumes continues to ramp towards management’s longer-term goal of 5,000 per month, and 3) Homes profitability (at both a unit level and an all-in level) continue to trend in the right direction.