Online real estate company Zillow Group (NASDAQ: Z) disappointed shareholders as Q3 results brought bombshell news. The company is winding down its Zillow Offers operations. And due to an operational mistake, it must now sell 7,000 homes for less than it paid.
Why is Zillow stock falling?
Q3 revenue in Zillow's Homes segment fell below company guidance, coming in at $1.2 billion instead of $1.45 billion. This is because some of the properties expected to close in Q3 will not close until Q4. The labor shortages caused by COVID-19 lockdowns have no doubt added to capacity constraints in renovation and resale.
As Zillow is primarily a platform for real estate agents to post their listings, many people are unaware that it also buys and sells properties independently.
But its 'Zillow Offers' division, widely recognized as its iBuying service, has Zillow acting as the broker in buying and selling homes. With the real estate market enjoying a boom year, investors were hopeful the iBuying service would bring decent returns.
Unfortunately, this was not to be, leaving investors high and dry. The Zillow share price has dropped 20% since its high last Friday. Worse still, that's 56% off its 52-week-high.
Zillow Group co-founder and CEO Rich Barton said:
"We've determined the unpredictability in forecasting home prices far exceeds what we anticipated and continuing to scale Zillow Offers would result in too much earnings and balance-sheet volatility,"
Losing money in a booming market
While the core business still appears to be strong, its buying and selling segment is subject to extreme volatility. Zillow no longer considers this a viable business going forward and is opting to wind it down.
Zillow Offers competes with Redfin (NASDAQ: RDFN) and OpenDoor (NASDAQ: OPEN) with the promise to pay cash and streamline the selling process.
As housing prices soared, Zillow and its competitors have been on a buying spree. They were betting the boom would last, allowing them to make billions in flipping thousands of homes.
Unfortunately, it overextended and now has a surplus of 7,000 homes to shift. Rumor has it, the company will sell them to institutional buyers at less than it paid. Its target price is $2.8 billion.
This excess inventory is thanks to a technical hitch in its algorithm. According to a Bloomberg report, as US real estate prices soared, Zillow tweaked its algorithms to offer higher prices to sellers. It then won the bids and paid over the odds for too many properties. Now it has to renovate and sell these homes, most likely at a lower price than it paid due to a slowdown in the market.
Zillow's usual state of play is to sell small numbers of homes to single-family landlords. As it has more than usual to shift, it is looking to institutional buyers.
Meanwhile, the US housing market is in disarray. In many areas, houses are being snapped up within minutes of being listed and for way over the asking price. This is not sustainable and is deemed very unfair for those trying to purchase a home to live in.
Therefore, it's understandable that consumers feel anger towards institutional ownership of homes as it exacerbates the problem.
Writing off inventory and cutting workforce
Zillow Group bought 3,800 homes in Q2 and around 8,000 in Q3. It intends to offload its inventory over the coming few quarters. During which time, it will also cut its workforce by 25%.
Furthermore, Zillow has written off $304 million worth of inventory from its Homes segment in Q3. And it expects to have to write down a further $240 million to $265 million of losses in Q4. This is based on homes it plans to purchase in Q4.
And why would it be continuing to buy in Q4 when it's trying to offload 7,000 properties? It seems the company is under contract to purchase additional homes it expects to acquire in Q4. And it expects to resell these at less than it paid.
Should you buy shares in Zillow?
There are two sides to this debate. If Zillow streamlines and strengthens its core business, it could go on to thrive and survive far into the future. But the alternative view is that it has mismanaged its Homes division, badly misjudged the market and taken investors for a ride.
There's no doubt it's a highly competitive business, and margins are slim. If the housing market slumps, Zillow won't look so good.
Algorithmic buying is only as good as its design. In this case, not very good. But Zillow appears to have faced up to its error and is attempting to get out before things spiral well and truly out of control.
Zillow's internet, media, and technology (IMT) division is its legacy business. It profits here from the advertising revenue and fees it charges to real estate agents and landlords for listing their properties. And this segment still appears to be thriving.
IMT Segment Q3 Highlights:
IMT segment EBITDA margin of 43.1% beat expectations.
Mortgages segment revenue grew 30% year-over-year to $70 million, exceeding guidance.
Q3 IMT revenue grew 16% year-over-year to $480 million and 43% on a two-year stacked basis compared to Q3 of 2019.
IMT segment revenue growth continued to benefit from its Premier Agent business
Zillow is improving connections between its high-intent customers and high-performing agents, driving higher monetization.
Zillow's Rentals business decelerated primarily due to a difficult comparison in Q3 due to abnormal seasonality in 2020.
By winding down Zillow Offers, it can focus its efforts on bolstering IMT by freeing up cash flow and resources.
Nevertheless, Zillow Group has been a tech stock favorite in recent years and, as such, has been priced for perfection. With all things considered, there's a good chance Zillow is still highly overvalued.
Zillow's forward price-to-earnings ratio is 128x. Its price-to-book value is 4x, and the $22 billion company doesn't offer a dividend.
Brokers are lowering their estimated price targets across the board, but consensus remains higher than the current price at $111 a share (according to FactSet). That gives a potential upside of 27%.
In his closing remarks, Zillow Group co-founder and CEO Rich Barton also stated:
“Look, similar to other leading technology companies that have gone before us, we strongly believe in taking big swings and failing fast. We have learned from our experience in Zillow Offers in Q3 and are applying those learnings as we look ahead.”
Highlights of Zillow's Q3 financial results:
Consolidated Q3 revenue of $1.7 billion.
IMT segment revenue growth of 16% year-over-year to $480 million, and Premier Agent revenue growth of 20% year-over-year to $359 million.
Homes segment revenue of $1.2 billion, below the company's Q3 guidance of $1.45 billion at the midpoint of the range.
Mortgages segment revenue growth of 30% year over year to $70 million, exceeding company guidance.
Consolidated GAAP net loss of $328 million in Q3.
Consolidated Adjusted EBITDA loss of $169 million with Adjusted EBITDA for the IMT and Mortgages segments exceeding the high end of the company's Q3 outlook.
The company ended the third quarter with cash and investments of $3.2 billion.
Justin Ross, co-founder of Opendoor tweeted:
The market seems to believe Zillow’s failure means Opendoor is also failing.
My belief is that Opendoor’s comparative accuracy (let alone operational advantages) led to Zillow having a huge adverse selection problem. Will know for sure next week, but I remain extremely bullish
— JD Ross (@justindross) November 2, 2021
Justin D Ross, co-founder of Opendoor
Opendoor itself subtweeted Zillow’s earnings to confirm its business model is strong and to reassure shareholders:
Opendoor is open for business. We have demonstrated strong growth and unit economics, and we are energized to help homeowners nationwide move with simplicity, certainty and speed.
— Opendoor (@Opendoor) November 2, 2021
Opendoor reassures shareholders