Brief Dive into Z

Investors have been rushing out of the stock following the company's decision to exit iBuying...and overlooking an incredibly strong core business

Zillow is a contrarian long as it currently is exiting the low-margin, high-risk iBuying business which management frequently touted as the next growth phase of the company. I always thought the company’s foray into iBuying spelled disaster and should have been avoided entirely. Investors who were bought into the growth story of Zillow being successful in this new business line have lost faith in company leadership, who up to a few quarters ago were highly optimistic about iBuying and signaled that it would be a more successful segment for the company (CEO Rich Barton compared iBuying to Netflix's streaming division and the legacy, lead gen business to Netflix's subscription DVD service). As you can see below, shares are currently trading at less than 25% of the 52-wk high:

Despite the pessimism over recent narrative changes, Zillow's Internet, Media, and Technology (IMT) core business has strong competitive positioning and when you strip out the negative EBITDA from the iBuying, Zillow trades at around 17x core EBITDA (my hypothesis is that some investors may be over-looking Zillow in the first place because it doesn't screen well).

Regarding the financial profile of the core business: IMT is a 90% gross margin business, and EBITDA margins have grown from 20s to 40s. The IMT also has zero capex associated with it, and high free cash flow conversion. With a sizeable chunk of federal NOLs, Zillow won't be paying cash taxes in the near future.

Currently Zillow generates ~75% of its IMT revenue from its flagship product, called Premier Agent. Realtors basically bid for leads in a specific zip code that are generated every time a prospective buyer clicks the "Contact Agent" button on a listing they are interested in. Realtors, for better or worse, are highly dependent on Zillow, which has the best SEO and therefore the largest audience of viewers. The following is a quote from a former realtor describing the service: “Agents sometimes say Zillow doesn’t have all the listings…they’re wrong, Zillow pretty much has all the listings. As an agent you have to be dependent on Zillow because that’s where people shopping for a home are coming from. Zillow has agents by the throat.”

Zillow is introducing a new product - called Flex - which allows agents to share 35% of their commission fees once a deal is closed rather than pay for leads upfront. Flex currently makes up ~10% of the Premier Agent business yet has the potential to greatly expand as the company is currently rolling it out only in select zip codes. I believe Flex will reinvigorate growth in the Premier Agent business, which was temporarily stalling a few quarters ago and even went slightly negative. Realtors will be strongly inclined to sign up, since they do not have to pay upfront the way they typically had to with leads. More notably, the company’s TAM dramatically expands from real estate advertising to the total size of commission generated from real estate sales in the U.S. You could make the case that the company was close to saturating its TAM if you believe it is the former. When you consider TAM to be the latter, Premier Agent is ~1% of TAM.

The other 25% of the IMT business represents highly underpenetrated opportunities - such as rentals, display ads, home financing, title insurance, etc. As the company has more time to focus on the IMT business, those represent significant growth opportunities from here on out. The company has only recently gotten into rentals, and is charging $9.99 a week for rental listings (a massive opportunity when you consider how many rentals are currently available in the U.S.). There is no reason to believe Zillow can’t dominate rentals the same way it dominated home buying. If Zillow owns its current customer (which it does), there is also no reason to believe it can’t up-sell ancillary products like title insurance by directing them to service providers and charging a fee.

I think a major catalyst for Zillow will be exiting iBuying and unloading its portfolio of homes. My hypothesis is that there is more than enough appetite from the major real estate investors like Blackstone, Brookfield, etc. who will buy chunks of the portfolio outright. Once investors stop contemplating future losses from the sale of these properties, and become more focused on the core IMT business, I think Zillow could be a winner.