2023-07-12 03:03:22 ET
Summary
- Zillow's stock has been performing well due to better-than-expected housing market conditions, however, market conditions are far from normal.
- Z is focused on increasing customer transactions and revenue per transaction through initiatives like financing, and seller tools.
- As a result of these efforts, the company has been outperforming the housing market, but growth is likely to remain weak until either mortgage rates or home prices are correct.
Zillow's ( Z ) stock has steadily moved higher in recent months on the back of better than expected housing market conditions. Sentiment towards the stock is also improving, with Piper Sandler recently upgrading Zillow from neutral to overweight, largely due to an expectation of improving macroeconomic conditions.
While mortgage rates have stabilized and new home sales are increasing, the housing market remains a long way from normal. The large supply of new housing units in the pipeline could pressure prices and rents going forward, although this would likely benefit Zillow through greater transaction volumes and increased demand for advertising.
Since I last covered the stock in February , Zillow is up modestly, which is probably more the result of greater investor risk appetite than anything else. As expected, the housing market remains fairly depressed, although greater supply from new builds is yet to make an impact. Zillow's new product efforts are progressing, despite difficult market conditions, although it is too early to assess their long-term success. The company remains well positioned, but macro uncertainty makes the stock risky in the near-term.
Market
While the housing market has stabilized somewhat, it hasn't really rebounded in any meaningful way. The number of transactions remains depressed as higher mortgage rates have created a gap between what sellers want and what buyers are able to pay. Zillow believes that there will be something like 60 million home transactions in the next decade, but current activity is well below this level.
Home builders are capitalizing on this situation through a combination of price cuts and mortgage rate buydowns. A rate buydown is where the builder covers some of the cost of the mortgage to help reduce the rate for the buyer. The buydown can reduce the rate for a period as short as two years or as long as the life of the mortgage. Builders are able to do this at the moment as margins are still elevated relative to pre-pandemic levels, and the buydown generally amounts to a fairly modest discount on the total home price. Roughly 75% of builders are offering lower mortgage rates and 32% are offering buydowns for the entire length of the mortgage.
Discounts and rate buydowns explain why new home sales are surging, but Zillow really needs to see greater existing home sales for its business to recover. While volumes appear to have bottomed, it is not clear what will break the current deadlock in the market and create a return to more normal conditions.
Figure 1: Home Sale Volumes in the US (Created by author using data from The Federal Reserve)
There is a record supply of new homes and apartments under construction, with particularly large activity in multi-family units. As this inventory begins finding its way onto the market, vacancy rates are likely to move higher. Over the next 1-2 years, there is a strong possibility that rental vacancy rates will become elevated, leading to depressed rents and in turn pressuring home prices.
This is probably the best-case path towards a return to more normal transaction volumes for Zillow, as a significant decline in mortgage rates is unlikely to occur without a severe economic downturn.
Figure 2: Home Vacancy Rates in the US (Created by author using data from The Federal Reserve)
Zillow
Zillow is investing in improving conversion rates and capitalizing on its dominant position at the top of the home buying funnel. The company wants to increase the number of customer transactions and its revenue per transaction through 5 primary initiatives:
- Touring
- Financing
- Seller solutions
- Enhancing its partner network
- Integrating with offline partners
The company expects these efforts to increase its share of customer transactions from 3% to 6% by the end of 2025.
Real-time touring is a focus for Zillow at the moment, as this potentially helps with depressed transaction volumes. Real-time touring is enabled by Zillow's integration with ShowingTime, and allows buyers to arrange a tour in under an hour. Experience so far in Atlanta indicates that touring customers convert at a higher rate than non-touring customers. Real-time touring is now also being rolled out in Raleigh, Denver and Phoenix.
Financing is another focus area for Zillow, but elevated mortgage rates are making progress difficult. Zillow believes that financing is important as the majority of home purchases are financed with a mortgage. 40% of all homebuyers start their journey shopping for a mortgage, and 80% of those don't have an agent. A solid financing business would help Zillow strengthen its control of leads and improve monetization. Zillow also has a significant CAC advantage in mortgages, which, in some cases is only 25% of the typical industry cost .
Zillow is building a first-party DTC purchase mortgage origination business. This effort is nascent though and Zillow is still trying to build brand awareness for Zillow Home Loans. The company is making progress though, with around 1 in 3 Premier Agents introducing customers to Zillow Home Loans in its enhanced markets. Purchase loan origination volumes also doubled YoY in the first quarter, although volumes have been fairly flat over the past 3 quarters.
Zillow is bullish on the prospects of generative AI but also recognizes the risk of this type of technology altering the flow of leads on the internet. This is something that Zillow is currently investigating, but the risk is probably minimal in the short term. In a similar manner, many people were sure that ChatGPT was going to doom Google ( GOOG ), and yet it appears to be having limited impact on search engine market share. Zillow is also protected by the fact that over 80% of its traffic is direct , meaning it isn't particularly dependent on channels like search engines.
Zillow is not new to AI either, with its Zestimate being an important part of the company for a long time. Zestimate has become more sophisticated over time, and the company is now also leveraging AI in other areas:
- Computer vision-powered media experiences
- AI-generated floor plans
- Natural language search queries
Zillow expects AI to improve the experiences of its customers and partners, and improve the productivity of its employees. This type of commentary is obligatory at the moment though and there is no reason to expect AI to have a significant impact on Zillow's business in the near term.
Financial Analysis
Total revenue in the first quarter was 469 million USD . While this was a significant YoY decline, Zillow is now close to lapping the exit of its Homes business and could return to YoY growth in the second half of the year. Residential revenue was down 14% YoY, although outperformed the industry total transaction dollar decline of 27%. New construction revenue increased 16% YoY on the back of builder incentives driving transaction volumes. Rentals revenue increased 21% YoY, with rentals traffic on Zillow growing 16%. Zillow expects its rentals business to be aided by higher vacancy rates leading to increased advertising demand from landlords.
Total revenue in the second quarter is expected to be 451-479 million USD, implying an 8% YoY decline at the midpoint.
Figure 3: Zillow Gross Profit Growth (Created by author using data from Zillow)
Search data for Zillow continues to point towards soft demand, although website traffic has been a lot more positive. Traffic to Zillow's mobile apps and websites in the first quarter was 212 million monthly unique users, flat YoY. Visits during the same period were down 5% YoY.
Figure 4: Zillow Search Interest (Created by author using data from Google Trends)
Zillow's margins have now largely recovered after the exit from the Homes business, although operating profit margins are still depressed due to investments in future growth. A return to a more healthy demand environment should see Zillow realize operating leverage and return to profitability. The company's ultimate long-term profitability will be dependent on the success its efforts in areas like financing and seller solutions.
Figure 5: Zillow Profit Margins (Created by author using data from Zillow)
Job openings at Zillow remain low, which doesn't suggest any recent acceleration in the business. This should be supportive of margins but highlights the difficult environment in which Zillow is operating.
Figure 6: Zillow Job Openings (Revealera.com)
Conclusion
Despite the move higher, Zillow's stock still isn't particularly expensive given the company's long-term potential. The stock price should also be supported by Zillow's large cash balance and opportunistic stock repurchases. The housing market is likely to remain unhealthy in the near-term though. Prices haven't adjusted to higher mortgage rates, and outside of cash buyers and buying aided by builder incentives, the market remains largely frozen.
For further details see:
Zillow: Solid Performance In A Tough Housing Market, Hold