Zillow (NASDAQ:ZG, NASDAQ:Z) has had a strong start to 2018. ZG stock (the Class A shares, which are slightly cheaper than Class C shares) has gained 58% so far this year and touched an all-time high this week.
The rally makes some sense. Indeed, I argued that investors should buy ZG stock in the mid-$40s in February. ZG stock wasn’t cheap then, but impressive growth and the potential for margin expansion suggested the stock could grow into its valuation — and then some.
But above $60, the bull case is tougher to make. Zillow’s entry into actually buying homes looks like a low-reward, high-risk move. Competition in that space, and online real estate more broadly, is intensifying.
Analysts aren’t particularly bullish. And the housing market doesn’t look particularly strong. There are a number of potential near-term headwinds, all of which are reasons to step to the sidelines here.
ZG Stock Doesn’t Look That Expensive
Zillow stock obviously is a growth play, and it’s priced as such. ZG trades at almost 8x 2018 revenue on an enterprise basis, and 60x+ 2019 EPS estimates.
But 2018 guidance shows an ability to grow into those valuations. Excluding the addition of the Instant Offers business (more on that in a moment), revenue is expected to rise over 20%, and adjusted EBITDA should increase more than 25% year-over-year.
Growth isn’t necessarily likely to slow down in 2019 — or any time soon — as more real estate transactions move online over time, and as Zillow expands its offerings.
Meanwhile, other web plays are trading at similar levels. Web developer Wix.com (NASDAQ:WIX) trades at almost 8x sales as well, and 84x forward EPS. Match (NASDAQ:MTCH) trades at 9x revenue, even after plunging amid the entry of Facebook (NASDAQ:FB) into its space, though as a more mature company, its profit numbers are better.
WIX and MTCH aren’t perfect peers for ZG, obviously. But the point is that the valuation of ZG stock isn’t prohibitive or out of line. Indeed, Zoopla, often referred to as the “Zillow of the UK,” is being acquired by a private equity fund for about 9x revenue.
The company still has the ability to grow into what looks like a steep valuation. That said, ZG was more attractive earlier this year, at sub-7x revenue and more reasonable earnings multiples. And with near-term headwinds on the way, the higher valuation seems to leave little room for error.
Concerns for Zillow
The most obvious concern for Zillow at the moment is that the housing market doesn’t look particularly strong. Indeed, the market has clearly moved away from the industry so far in 2018.
The two biggest home builder stocks, Lennar (NYSE:LEN) and D.R. Horton (NYSE:DHI), both are down about 18% YTD. Housing starts looked strong at the beginning of the year, but recent data simply hasn’t been all that impressive.
Zillow can manage a flat or even declining market, but it will have an impact on revenue. But a downturn also raises a key risk as Zillow rolls out its “Instant Offer” program.
Instant Offer is what it sounds like, and it means Zillow will carry homes on its balance sheet. Post-Q1 guidance projects the company will own 300 to 1,000 homes in inventory by year’s end, a figure that should rise if the program is expanded.
That raises balance sheet risk if prices were to turn south. But even a flat market with slowing volume likely makes the program less profitable.
Meanwhile, rival Redfin (NASDAQ:RDFN) and startup OpenDoor are offering similar products. OpenDoor has raised some $650 million to back its efforts. Competition from smaller startups continues, with those companies trying to undercut the same real estate agents driving most of Zillow’s revenue.
None of these factors are necessarily major risks. The real estate market is large enough for multiple companies to prosper. A 2008-style crash in the housing markets appears unlikely. But with ZG’s valuation more stretched, there’s more possibility that concerns can lead the stock to fall. Meanwhile, Zillow no longer appears to have Wall Street behind it.
Wall Street doesn’t always get it right, but it’s worth noting that analysts are seeing similar valuation concerns when it comes to ZG stock.
The average target price now sits at $56, about 10% below current levels. Goldman Sachs (NYSE:GS) cited market weakness in a downgrade this week. Craig Hallum in April cited the risks related to Instant Offers in a cut to “Hold” that briefly sent Zillow stock tumbling.
That alone doesn’t break the long-term case for ZG stock. But in the near term, with the stock near an all-time high, it’s not hard to see a decline on the way.
The concerns about the housing market more broadly can make their way to ZG. Analysts at this point probably aren’t going to step up to defend the stock. It puts a lot of pressure on Zillow’s Q2 earnings in early August to keep the story going. Because at this price, the story will have to stay intact for ZG stock to do the same.
As of this writing, Vince Martin has no positions in any securities mentioned.