Z - A Joe's Pros Interview

Joe 

Good morning, it's Joe DeMatteo on November 30th, 2021, and welcome to the Joe's Pros interview. I understand you're bullish on Zillow at current prices, now trading around $55. Why don't you please go ahead and kick us off? 

Pro 

Yeah, sure. Thanks for doing this, Joe. I think Zillow is completely washed out here. I think that they've suffered a massive amount of narrative change and people are puking it as a result, with the major narrative change obviously being that they're exiting their iBuyer business after about three years of investment. I understand shareholders are upset because it's been a major messaging change. As recently as a quarter or two ago, they were saying that this is a great business for them. However, now that the Band-Aid is ripped off and the stock is down significantly, I think what is being misunderstood about the stock is that the core Internet, Media & Technology (IMT) business is extremely successful and, if anything, has probably been neglected by the management team over the last two years. Z has an ability to reinvigorate growth significantly in that business, and iBuyer is out of the way. They're likely to unwind that business relatively quickly, in my opinion, and the valuation at this point on the core IMT business is quite low. So, that's my kind of high level thesis on the stock. 

Joe 

I've read a decent amount about it recently. Investors obviously want to be with a good management team, and I think this management team had a lot of respect for a long period of time. This move into iBuying and what you described has caused that apple cart to be quite upset. Why don't you touch on that as it relates to making a fresh investment here? Give your perspective around that and then what we have left and / or however you would go about telling the story. 

Pro 

On management credibility, any time a narrative changes significantly, I understand that there's a significant hit on management credibility. That said, if you step back and you ask, “What is this management team good at and what have they done really well?” At the end of the day, they've created a category killer for real estate listings on the internet. They have like 70% share of all the traffic for people who are looking at real estate listings to buy or possibly even rent a house, and that's what they're good at. If you're looking up a house, you don't typically type the address into Google. You go to Zillow and you type in the address there and you see it. So, what's the company really good at? They're really good at creating a category killer in this listings and showings business. 

I would argue that iBuying is a big step away from that core competency. I would argue that that's a game where it's really more about just having a big checkbook, which Opendoor for the moment has. I don't think that there's anything really differentiated about an iBuyer business. I think at the same time, you could also argue that iBuying hurt the customer experience of Zillow because at the end of the day-- I think they touched on this last quarter-- something like only 5% of the iBuyer offers that were ever given were actually closed. So, if I'm trying to sell my house and I get a bid from an iBuyer and then they tell me we can't do it for whatever reason, that hurts my experience and I'm not happy with Zillow. So, I would argue that is ultimately a return to the roots for the company. This is a return to what Rich Barton does well, a return to the company's core competency, and I think this is the ability for them to pivot back to growth in the core business, which I think is what's so interesting. 

Joe 

That's probably an important point right there. Why did they go to iBuying in the first place? Was it because they felt that the growth was slowing or that they were challenged to grow and they needed to keep the momentum going in some way so they chose an ill fated avenue? How do you think about that? 

Pro 

I don't know what was in their minds when they launched iBuyer. I have my own views on iBuyer, but I think that at first there were probably two schools of thought in their heads. Number one, they probably thought that they could do it better than others. They invented the Zestimate.. That's kind of what makes Zillow, Zillow, is you could go look at your house and Zillow will tell you how much they think it's worth. They probably thought, “Look, we can probably do this better than others,” so there was an offensive opportunity for it. And number two, I think there were probably some defensive characteristics. In their mind, particularly three years ago, they were like, “Well, if the world goes to iBuyer or if the world goes to single family rental, does that mean down the road that agents get disintermediated? And then, IMT today gets all of its money effectively from agents. So, if agents are not there anymore, how would IMT make money?” I think it's pretty clear now that agent fees may be diminishing, but the agents themselves, even in an iBuyer setting, are still there. 

I think an interesting opportunity for Zillow going forward is if they can actually take more value away, not from the agent, but from the agency. So, in a world of work from home, does an agent who's really good have to share half of their splits with the agency? What are they really getting from the agency, particularly in the world of COVID where they don't use the office, they're working from home, and now they can get all their leads from Zillow? What do you have to pay these agencies half of your fees for? I think that's the opportunity, and that hopefully addresses why they got into it in the first place and also why that's not an issue going forward. 

Joe 

Can you address the Zestimate to begin with? I think one of the things they said in their mea culpa was that the estimators or the algos weren't working. Has that shed light in a negative way on the existing business? 

Pro 

Here's my view on this Zestimate on the iBuyer. A home is a 50-year asset. iBuyer is effectively a flipping business. So, if I'm going to buy a home because I've got a new baby on the way and I'm planning on being there for 20 years, if I pay 1% - 3% more or less for the house up front, it doesn't really matter. It all kind of goes out in the wash. But if I'm only holding the house for a month and I'm wrong by 2% - 4%, I'm screwed. I think the problem with Zestimate and iBuyer is not that it’s so wrong about the price of your home. Could it be wrong by a couple of percent? Sure. Does that mean the Zestimate doesn't work? No. Ultimately, homes are illiquid. It's a 50-year asset that in theory doesn't flip the way a security does. I don't think that it means anything about the quality of the Zestimate. It’s just that I don't think any estimate of an illiquid product can be exact down to 1% - 3% if you're only holding it for a month. If you're holding it for 50 years, that's good enough. If you're holding it for a month, that could hurt you. Ultimately, that's the problem with the Zestimate and candidly, that's my problem with all of iBuying. So, I don't think there's an issue with Zestimate. I don't think there's an issue with the underlying business. I just think it was a bad miss. Sure, you can hit these guys for pumping up a business and then cutting it, but at the end of the day, if you were running a business and you realized one of your divisions was bad, you should cut it quickly. I think that's the right decision. 

Joe

All right. Why don't we go through what we have now to a fresh buyer? It looks to me like it's a $15B enterprise value on an expected $6.7B of revenues and I don't know what's mashed in there. 

Pro 

Yeah, it's a little complicated. 

Joe 

Why don't you go through the financial analysis that you've done to come up with this as an attractive security here? 

Pro

The market cap right now is a little under $14B. There's about $1B of net debt, but it's important to note that's all convertible debt, so it depends how you want to treat the debt of the converts. I kind of think of it as being debt free because it's convertible and not hard debt, but we can talk about that. In my opinion, the EV if you convert the debt is anywhere between $12.5B - $14.5B. You can kind of think of it that way. 

The Bloomberg financials do not isolate the IMT and mortgages business. It kind of throws in everything, and iBuyer is a loss this year because they're taking significant writedowns. That kind of masks what the real EBITDA is. I think core EBITDA for IMT is about $800MM - $830MM this year. So right now, the valuation is something like 17x EBITDA, give or take, just purely on IMT. The interesting thing about IMT is it's a 90% gross margin business. They've grown EBITDA margins in that business from about 20% to the low-40s% this year and I think that there's more opportunities to cut costs and to grow margin from here, plus there is also the opportunity to keep growing the top line. That $830MM is very capex light-- there's no capex associated with it-- so the free cash flow conversion is very high. Also, these guys aren’t going to be paying cash taxes for the foreseeable future. So, the way I think about it is that this is a business that can reinvigorate growth such that in the next 2 - 3 years, you can be talking about a $1B or more of free cash flow a year. At a market cap of less than $14B, it's incredibly cheap for an incredibly high return on capital business. That's kind of how I think about it. We can also spend a minute, if it's worthwhile, talking about some of the levers they can pull to grow in IMT. I think those are significant, as well. 

Joe 

All right, let's get into those levers. 

Pro

Right now, 75% of IMT’s revenues come from their Premier Agent business, which is basically brokers bidding for share of voice and different zip codes to get leads. In addition to that, within Premier Agent, they have a product called Flex, which I think is super interesting. If you're a really good agent, you can sign up to be a Flex agent, which means that you don't pay anything upfront for the leads, but you give 1/3 of your commission to Zillow when you sell the house. So if you’re a really good agent and you want really good leads, you can become a Flex agent, not pay anything upfront, and just share the upside when you sell the house. That is a higher take rate for Zillow and a higher margin for Zillow. Right now, I think Flex is maybe just 10% of the Premier Agent business, but it has the opportunity to go significantly higher. Right now, it's only done on an invitation only basis and only in select zip codes. I think that is an opportunity to grow significantly. 

Joe 

Is that disintermediating the agency that a broker might work for where they're sharing the fees?

Pro

Not necessarily. If I have Flex, I could still be an agent at an agency, but then I still need to share the fee. In theory, though, yes, you're right. If I'm getting all my leads from Zillow, they're providing me all the listings, and I can advertise on my own, I don't necessarily need to have my flag with Coldwell Banker, Corcoran, or whoever. I can just do it solo. And then, instead of sharing my splits with the agency where I'm giving them half the splits, I'm only giving a third to Zillow and I'm keeping the rest. So it's a good point, Joe. 

Joe

Does that annoy your customer base? If that's the way it goes, what does that do to the relationship that Zillow has with the larger brokerage agencies out there? 

Pro

At the end of the day, Zillow is the enabler for all of them. If the agency is adding value, the agents will stay. If the agency is not, the agents can leave and just use Zillow. Ultimately, it's up to the agency to prove itself no matter what. If they fire Zillow as a result of that, they still need to add value for the agents, and how are they going to get their leads then? It's a little bit circular. I think they're kind of stuck with each other. 

The other part of the business, I think, is interesting. Think about that 25% of the IMT business that's not Premier Agent. That's rentals, display ads, home financing, title. If I buy a house, think of all the fees and payments that I have to make. Or, if I rent an apartment, I have to find the listing, I pay a broker, I have to set up a time to view it. These are all, in my view, under-penetrated opportunities. Rentals is a huge opportunity that Zillow is only just starting to get into. Why can't they be the Zillow for rentals the way they are for home purchasing? Home financing, title-- these are all things that I have to do as a home buyer that if Zillow owns me as the customer, which they do, why can't Zillow direct me to those service providers and get a fee for it? My perspective is that the management team always had that on their radar but has just been busy with iBuyer, trying to make that a fixable business, and now they can kind of reinvigorate growth here. 

The other thing that's worth pointing out is they bought a company for about $500MM earlier this year called ShowingTime, which is the leading online scheduling company for viewing a home. I think that's an additional opportunity to add more fees and add more value for both the customer and the agent, because that's a major hassle-- trying to figure out when you're going to tour the house, how you're going to get the house set up, etc. 

Joe

That makes sense. What are your differentiators to the buy side and/or sell side going into 2022 and 2023 in terms of your numbers and where you think this should shake out? Any inflection points, catalysts, etc.? 

Pro

If you think about what the catalysts are going to be, I think that number one, it's about them unwinding homes and just being done with it both at the income statement level and the balance sheet level. I think there's enough of a community in the SFR business where there's a real appetite for major SFR players to just buy the portfolio. If you're BlackRock, Brookfield, or some of these other places and you are trying to buy as many homes as you can, this might be your last, best opportunity to buy 3,000 homes at a time. So, if Zillow wanted to, they could easily just unwind this Homes business more quickly than people think, and I think that will basically just de-risk it. I don't think there should be any real concern that they can't get out of these houses. The housing market is still quite strong. I think that it could happen a lot faster if they just decided to because there's huge interest from Opendoor and all these other guys to just park money into homes. Why can't they be the Zillow homes? That is one thing. 

In my view, once they get out of Homes, they arguably have a very under-levered balance sheet. I think that there's an opportunity for them to buy back stock, particularly with the stock in the dumps the way it is right now. That's number two. 

Number three, I would expect them to have an analyst day at some point, hopefully in the first half of next year where they can kind of refocus investors and frankly retake control of the narrative. iBuyer happened, it was a mistake, okay. But I think the other thing that made this worse was they just lost track of the narrative. There were all these leaks about iBuyer, nobody is talking about IMT. These guys are going to have an analyst day and they're going to say, “Hey, here's the business. Here's the opportunity. Here's the additional fee pools that we think we have a right to penetrate. Here's the long-term opportunity. Here's the costs we're cutting.” I think that can kind of refocus attention, as well, and I would expect that to be in the next six months. 

Joe

Got it. Have you fleshed out estimates for the next two years? 

Pro

I don't want to claim that I've got any significant detail. I would just say that I think you're looking at a free cash flow of $1B+ in 2 - 3 years, and that's where the opportunity is. I just don't think the stock is going to stay at a $14B market cap if they're printing $1B of free cash flow a year with growth opportunities. The other thing I would say is, obviously I don't have any real data points on this, but if you're a tech PE fund, isn't this the type of business you dream of-- a category killer with growth opportunities that's out of favor in the public markets? The interesting thing about Zillow to me is that it has been an incredibly controversial stock since it came public. The stock was at $20 in 2018 or something like that. This has not been a happy story. So, in my view, if you're Rich Barton and you're like, “Look, I'm out of Homes, I'm free cash flow generating. What do I need to fight with all these investors for?” Being public has no advantages for him. Arguably, if you're private you can kind of re-pivot the business and refocus on growth without worrying about quarterly numbers. Mindbody got acquired in a similar situation. That was a much smaller company, but there are stories of this happening, like Dell. I don't think it's impossible to think that some tech-focused fund would express real interest here and just take it private. And why wouldn't Rich Barton do that? Everybody “hates” him, he’s controversial, so what does he need this for? 

Joe

Appreciate it. The last question I have is a macro one. With all the macro concerns on inflation and now the Fed is buying less securities and rates may start rising, what does that do to the housing pool and activity? 

Pro

If I'm going to be totally candid, I think what we don't really know yet is the cyclicality of the IMT business. I want to be transparent. If house price appreciation slows or even reverses, even if existing home sales are fine, it's sort of an open question of whether that means agencies are just willing to pay less. I don't know. I think there is some question about that. I would just say that Zillow isn't really, really levered to new construction. Zillow is levered to existing home sales, which is still running at that 6MM or something like that. I think that's ultimately where they're levered because that's 85%+ of housing transactions. So, I'm not so focused on recession risk. Also, arguably, we still have an undersupplied housing system in the US, so I'm not so worried about it. I do think there's probably some cyclical risk because maybe agents are less willing psychologically to bid more for zip codes if house prices are slowing down. At the same time, I think that's more than offset by the fundamental growth opportunities here. There's like $100B of fees paid in the real estate market every year between broker fees, agency fees, mortgage fees, and everything else. These guys are capturing 1.5% of it. Could it be 3%? Yeah, it could be 3%. Could it be 4%? Why not? That's how I think about it. Sure, there’s cyclical risk, but I would argue the cyclical risk is way lower now that they're out of iBuyer. If you want to be an Opendoor shareholder when house prices start going negative, is their algorithm really that good? 

Joe

All right. Well, you've been generous with your time and I appreciate it. Why don't we put a pin in it there? Thanks for your input and good luck with the investment. 

Pro

Cool. Thanks, Joe. 

Joe

Sure thing. Thanks. Bye.