Introduction & Investment Thesis
Zillow (NASDAQ:Z) is an online real estate marketplace that has severely underperformed the S&P 500 and Nasdaq 100 YTD. The company reported its Q1 FY24 earnings on May 1st, where revenue and earnings grew 13% and 20% YoY, respectively, beating estimates. However, the stock declined 6% after earnings.
While the decline in the stock price post-earnings could be related to the management’s guidance for its Residential Revenue segment in Q2, where it expects a deceleration, given elevated mortgage rates and the underperformance of first-time homebuyers, I believe that the post-earnings selloff has presented an attractive entry point for long-term investors.
I believe that Zillow’s stock is positioned for significant upside, given its robust product innovation to attract high intent buyers that convert more efficiently, allowing its Residential revenue segment to grow faster than the industry average. I am also optimistic about the growth in Zillow’s Rental segment in the coming years, especially as it focuses on multifamily listings. Meanwhile, the management remains financially disciplined, as Adjusted EBITDA margins are expected to expand modestly in FY24.
About Zillow’s business model
Zillow is an online real estate marketplace that provides a range of services related to buying, selling, renting, and financing homes.
The company generates revenue primarily across these three categories: Residential, Rentals and Mortgages. In the Residential category, Zillow derives its revenue from the sale of advertising services, as well as marketing and technology products that they offer through their Premier Agent program. At the same time, Residential revenue also consists of New Construction Revenue which includes advertising services sold to home builders. In the Rentals category, Zillow derives its revenue from advertising and offering a suite of tools to property managers and landlords, as well as when potential renters use Zillow’s rental application product for a flat service fee. Finally, the Mortgage category includes revenue generated from mortgage originations and the sale of mortgages on the secondary market through Zillow Home Loans.
The good: Residential Revenue outpacing industry average, Accelerating Rentals Revenue, Robust Product Innovation and Strong Margins
Zillow reported its Q1 FY24 earnings, where revenue grew 13% YoY to $529M, exceeding expectations by 4.3%. Out of $529M in revenue, Residential Revenue contributed 74.2%, growing 9% YoY, outpacing the transaction value growth rate of the residential real estate market. Meanwhile, Rentals and Mortgage Revenue grew 31% YoY and 19% YoY to $97M and $31M respectively.
I believe the revenue outperformance can be attributed to the following factors. First, Zillow had over 217M average monthly unique users across its apps and sites, which was flat YoY. At the same time, Zillow was searched more on Google than the category term “real estate” and three times more than its immediate competitors, which include Realtor.com and Redfin (NASDAQ:RDFN). I believe this showcases Zillow’s strength in its brand position, where it is bringing in high-intent customers organically, leading to faster revenue growth.
At the same time, Zillow continues to work with the most productive agents in the residential real estate segment, where Premier Agent Revenue has grown 2.5x since 2015, even though they have shrunk their active partner base by 60% during this time period. Furthermore, in order to attract superior agent teams, Zillow continues to innovate its technology in its Residential real estate segment to help agents become more efficient and conduct a higher volume of transactions.
For instance, the company is expanding its Real Time Touring solution to 34 markets by the end of May, bringing the total to 124 markets. In my opinion, the Real Time Touring solution is an efficient mechanism to connect high-intent buyers with Premier Agent partners, allowing agents to facilitate agreements earlier in the funnel in order to improve conversion rates.
Simultaneously, Zillow is also driving higher engagement among buyers and faster close rates with its AI-powered Listing Showcase solution, which provides a better shopper experience through rich media and floor plan technology. In fact, according to commentary from Zillow management in their Shareholder Letter, “Showcase Listings typically sell for 2% more than similar non-Showcase listings on Zillow, a bonus of $9000 on a home sold at the average home sale price in the US." I believe this is creating a win-win for all, as improving buyer engagement is translating into higher value for sellers and agents. As Showcase Listings gain a higher percentage of total listing coverage, I believe that Zillow will stand to benefit from unlocking a larger revenue opportunity as agents are able to win faster with a higher sale value.
Meanwhile, Zillow continues to focus on its Zillow Home Loans Solution in order to provide a more seamless experience for customers, agents, and loan officers. In Q1, the company saw a 130% YoY increase in loan origination volume to $601M, which accelerated the growth in their Mortgage segment. In fact, according to the company’s Shareholder Letter, Zillow is seeing double-digit adoption rates of its Home Loans Solution in its 13 Enhanced Markets in Q1, resulting in higher revenue per customer transaction YoY.
Finally, turning our attention to the Rentals segment, Zillow is rapidly innovating to grow in the “multifamily” rentals space after seeing success in “long-tail” rentals, which primarily consist of single-family homes. Since they turned their focus on the “multifamily” rental space, they have seen a 36% compound annual growth rate (CAGR) in their “multifamily” revenue. I believe that combining longtail listings with multifamily listings in one marketplace will allow Zillow to differentiate itself, especially as it continues to invest in their rental products, services, and sales to drive growth. I also believe that given the uncertain macroeconomic environment, where interest rates are kept higher for longer and housing affordability is at an all-time low, many Americans are turning to renting, which creates a significant revenue opportunity for Zillow, especially as Zillow reaches over 40,000 multifamily properties advertising on its platform in Q1.
Shifting gears to profitability, Zillow generated $125M in Adjusted EBITDA, which grew 20% YoY at a margin of 23.6%, compared to 22.1% in the previous year. The improvement in profitability was primarily driven by revenue outperformance in its operating segments, especially Residential Revenue, as well as a continued focus by the management to streamline operating expenses.
The bad: Higher for longer interest rate environment can weaken the housing market, Management guides for a deceleration in Q2 Residential Revenue
I believe the housing market today is in a gridlock, where housing inventory for existing homes is at abysmally low levels, as many potential sellers are holding onto their lower-rate mortgages. As a result, the median price of existing homes has stayed resilient, despite high mortgage rates and declining sales volume. On the other hand, the new home market is a slightly different story, where new home sales are growing with inventory levels above pre-pandemic levels. I would like to point out, however, that the existing home market is much larger compared to the new home market, making up 85% of all transactions. At the same time, with interest rates kept higher for longer, as inflation is proving to be more stubborn than anticipated, there is a growing concern about a weakening of the US labor market, which would inherently affect housing demand and prices, thus impacting Zillow’s Residential Revenue component. In fact, the management expects the total transaction value in the residential real estate industry to be flat YoY in Q2, decelerating from the 4% YoY growth in Q1. As a result, the management has guided their Residential Revenue to grow at a slower pace sequentially of 5% YoY at $372-$382M, as they believe that interest rate volatility will likely keep mortgage rates high and first time homebuyers will continue to be under pressure.
Tying it together: Zillow is a "buy.”.
Looking forward, Zillow expects to grow its revenues in the low double-digit range in FY24, with modest Adjusted EBITDA margin expansion. Taking the consensus expectation into consideration, I expect Zillow’s revenue to continue growing in the low double-digit range over the next 2 years until FY26, resulting in a total revenue of $2.78B. I believe that this growth rate is reasonable as long as the US economy does not enter a prolonged period of recession, which hurts the housing market. In this scenario, we should continue to see a relatively strong labor market that supports the fundamentals of residential real estate, as Zillow continues to draw high-intent customers with its product innovation in Touring, Financing and expanding Seller services such as Showcase Listings to engage and convert prospective buyers along the customer journey more efficiently. At the same time, I also believe that Zillow is well positioned to drive growth in the Rentals segment, as housing affordability will continue to plague the US economy, even though it doesn’t experience a significant slowdown or a recession.
Assuming that Zillow is able to maintain its Adjusted EBITDA margins at 21-23% during this time period, as it continues to attract high-intent customers on its platform as well as management focuses on optimizing costs, it should generate an Adjusted EBITDA of $640M by FY26, which would be equivalent to $235M, when discounted at 10%.
Taking the S&P 500 as a proxy, where its companies grow their earnings on average by 8% over a 10-year period, with a price-to-earnings ratio of 15–18, I believe that Zillow should trade at roughly 1.5x the multiple, given its rate of earnings growth. This would result in a PE ratio of approximately 25, which would translate to a price target of $51, representing an upside of 31%.
I believe that the post-earnings sell-off has created an attractive entry point for long-term investors, as I believe the company is well positioned to innovate its ecosystem of solutions that create a superior experience for all the players involved in the buying, selling, and renting of homes while maintaining its focus on profitability.
Conclusion
I believe that Zillow has upside over a 3-year investment horizon as the company continues to navigate a complex macroeconomic and housing environment while building on its growth pillars to drive robust innovation to attract, engage, and convert high-intent buyers, resulting in faster revenue growth than the industry average. At the same time, I believe that Zillow should see robust growth in its Rentals segment in the coming years. Assessing both the “good” and the "bad," I believe that Zillow has presented an opportunity for long-term investors to initiate a position, making it a “buy”.
Amrita Roy
Amrita runs a boutique family office fund in beautiful Vancouver, where she leads the investment strategy for the family fund. The fund's objective is to invest capital in sustainable, growth-driven companies that maximize shareholder equity by meeting their growth-oriented goals. In addition, she also started her own award-winning newsletter, The Pragmatic Optimist which focuses on portfolio strategy, valuation, and macroeconomics in concert with her husband Uttam Dey who is also a contributor on Seeking Alpha. Prior to cofounding her fund, Amrita worked for 5 years in high-growth supply-chain start-ups in downtown San Francisco, where she led strategy. During her time in the Bay Area, she also worked with venture capital firms and start-ups, where her efforts led her to grow the user acquisition business. During this time, she was introduced to investment portfolios and was able to maximize returns for clients during the pandemic. The cornerstone of Amritas work rests on democratizing financial literacy for everyone and breaking down financial jargon and complex macroeconomic concepts into formats that are easily digestible but more empowering than the typical investment thesis. Her newsletter has been featured as the Top Newsletter in Finance on popular newsletter platforms and she aims to bring her ideas to Seeking Alpha as well.
Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, but may initiate a beneficial Long position through a purchase of the stock, or the purchase of call options or similar derivatives in Z over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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