2023-12-23 01:25:45 ET
Summary
- Zillow's stock price surged 23% on news of planned interest rate cuts, potentially benefiting its business.
- A $13 billion market cap seems more than reasonable for a market leader in a lucrative industry.
- However, caution is advised due to housing market conditions and Zillow's recent price volatility.
Real estate website Zillow ( ZG ) has evolved into an integrated real estate marketplace. Despite industry challenges, the company is innovating products and services to capture more of transaction values over time. The US housing market is experiencing a sharp cyclical correction but for long-term investors, Zillow offers an attractive risk-reward investment as housing recovers.
The State of Housing
The state of housing in the US is in bad shape. Existing home sales declined for 9 straight months to the lowest level since 2010, inventory stands near historical lows, and new construction lags population growth by over 4 million units.
Rapid interest rate rises have reduced the affordability of buyers looking to move. At the same time, many homeowners are unwilling to move since they have locked-in mortgage rates much lower than currently offered. According to CNBC, more than 80% of US homeowners have mortgages under 5%. Meanwhile, the latest 30-year mortgage rate according to FRED sits well above 6%. In this context, it's no surprise that real estate companies like Zillow have come under stress this year.
Still, favorable demographics, migration, and structural undersupply mean the downturn could prove relatively short-lived in contrast to 2008. Mean reversion in rates and increasing demand could set the stage for mid-single digit transaction volume growth to resume through the back half of the decade. Against this market backdrop, Zillow aims to leverage its audience reach and brand equity to substantially grow share.
As interest rates come down, we can expect some strengthening in the housing market. And that is precisely what happened last week. Zillow's stock price jumped 20% on news that the Federal Reserve plans to make three interest rate cuts in 2024. Rate cuts will stimulate housing demand, which in turn benefits Zillow.
Recent Events and Fundamentals
At the recent market price, the company has a market cap of $13.2 billion. That valuation looks rich when considering recent financials. Trailing twelve month revenue sits at $1.9 billion, with only $223 million of free cash flow. However, on a longer term horizon, Zillow stock is down more than 70% from its all-time high. And the company has shown signs of profitability in the past.
Importantly, Zillow's financials reveal what can happen when the housing market eventually warms up. In 2021, when excluding Zillow's ibuying business, the company earned over $800 million of adjusted EBITDA on revenues of just $2.1 billion.
In other words, when housing comes back, we can expect Zillow to generate significant profits. Perhaps not at the same level as in the boom year of 2021. But with gross margins of 79%, Zillow benefits from significant operating leverage. More transactions through the platform generate profit at a higher rate.
Leading Brand and Audience
The Zillow website sees 225 million monthly users, which is more than double its closest rivals. According to Semrush, global web traffic remains strong despite the obvious downturn in housing.
Semrush
Strong consumer mindshare and intent-rich data are providing Zillow with a competitive advantage against peers. Management have spoken in the past about 80% unaided awareness. Essentially, the majority of visitors land on Zillow through brand recognition. Zillow doesn't need to spend large amounts on advertising or search engine marketing.
Meanwhile, Zillow is working to integrate services across touring, financing, and seller solutions to increase customer conversion. Though early, integrated buying tests show promising traction with higher satisfaction scores and agent participation. Rentals is also an opportunity for growth. In the most recent quarters, revenue from rentals increased by 34% year over year. Repeatedly, Zillow has leveraged its audience and data strengths to create new models and revenue streams. Crucially, this is a very large TAM. And online penetration in the $2+ trillion global housing market remains in its infancy at just ~10%, providing a long runway for Zillow to increase share. The company estimates a $50 billion revenue opportunity long-term just in the US across its existing businesses.
Significant Risks
Despite being a market leader, a great deal of caution seems warranted given market conditions. The Fed's planned rate cuts, while positive, may not provide as much upside as expected. Even at 6.5%, mortgage rates would still price many buyers out of the market. With millions locking in sub-3% mortgages in recent years, supply constraints are likely to persist. At the same time, new housing starts are not showing the kind of progress needed to alleviate the housing shortage. In theory, new homes should come to market and that should help Zillow. In practice, the amount of supply coming may not be at a level that is meaningful.
There is also execution risk. Zillow can be praised for its creative approach to trying new revenue streams. But it has to be said that the ibuying business (now shut down) was a disaster. It began at the worst possible time and ended in the company losing over $1 billion .
Meanwhile, Zillow faces new digital competitors across financing, CRM, and other transaction services. Well-funded players like CoStar, Offerpad, and Realogy threaten its share and the Zillow super app remains unproven.
Lastly, industry lawsuits highlight how government oversight around commissions, listings access, and related practices remains fiercely unsettled. Adverse legal or regulatory changes pose risks to certain Zillow revenue streams. Although it could be argued that they would affect rivals more than they would Zillow.
Back of Envelope Valuation
When valuing Zillow it's crucial to consider two factors. First, that 2024/2025 will likely see slow growth as housing will continue to be supply constrained. However, as interest rates ease, there will be a significant amount of pent up demand. The second thing to consider is that, post 2025, Zillow could see much stronger growth due to the unwinding of pent-up demand. Accordingly I have modelled the following revenue growth rates over the next 5 years:
Year | Revenue Growth (estimate) |
2024 | 5% |
2025 | 10% |
2026 | 30% |
2027 | 20% |
2028 | 20% |
In this scenario, starting from $1.9 billion today, Zillow can be expected to produce $4.1 billion of revenues by 2028. With a 25% net income margin (similar to other marketplace businesses like Airbnb) I estimate the company could be making $1.03 billion in net income in 5 years' time. Considering the growth and size of TAM I believe a 25 multiple would not be out of line. Such a multiple would then give Zillow a market cap in 5 years of $25.7 billion which works out to a 5-year CAGR of 14.2%.
Importantly, this seems like a conservative estimate. The effect of pent-up housing demands means revenue growth could come in much higher and as a consequence also lead to a higher valuation multiple.
The Bottom Line
Zillow’s expansive vision for an integrated, one-stop housing platform makes the stock an intriguing prospect. But there are significant risks to consider, not least the fact that the US housing market is effectively frozen with interest rates at their current levels. However, we have on offer a market leader with high operating leverage and brand equity. One that can profit from one of the largest markets; US real estate. $13 billion seems like good value for the long-term potential that Zillow offers.
For further details see:
Zillow Can Provide Double Digit Returns