Digital real estate giant Zillow (NASDAQ:Z) just reported second-quarter numbers that were largely in line with analyst expectations. But, management gave a weak forecast that was below consensus estimates across the board for both next quarter and the full year. Consequently, Z stock is dropping like a rock. As of this writing, Z stock is down more than 15%. Unfortunately, I think there is more pain ahead.
There is no hiding the fact that Zillow is a growth stock with a hefty valuation. Heading into the print, Z stock was trading at over 90 times forward earnings for what analysts thought was going to be 40% revenue growth this year. The high-growth part of that combination is, however, falling apart. Revenues are only supposed to rise 24% this year — a sharp reduction from analyst estimates.
Thus, the premium investors are willing to spend for Zillow’s growth is also normalizing to more sustainable levels. But there’s more room to fall from here.
The reality is that Zillow is a fundamentally unique business with a large moat and healthy following. But, it is also relatively niche, and the best of its growth story is in the rear-view mirror.
After the big drop, Z stock still trades at a multiple of 80. That multiple is simply too big considering the slowing growth nature of this company. As such, I fully expect weakness in shares to persist until the low to mid-$40s.
Here’s a deeper look:
Zillow’s Quarter & Guide Point to Slowing Growth
The positives about Zillow are that the audience is growing, revenues are growing, and margins are largely expanding. This trio of tailwinds has sparked an 80% rally in the stock over the past three years.
But, the negatives are that across the board, the positives are starting to lose momentum.
Audience growth? Monthly active users were up just 4% in the second quarter. That compares to an average 11% growth rate over the past several years. Therefore, it looks like Zillow’s reach is maxing out as it nears 200 million users.
Revenue growth? Revenues last quarter and year-to-date are up 22%. Last year, revenues were up 27%. The year before that, revenues were up 31%. Thus, revenue growth is clearly on a decelerating path, largely due to the fact that user growth is also slowing.
Margin expansion? This has been a huge margin growth story for a long time now. Investors have been really excited about Zillow because the company operates at 90%-plus gross margins and can be hugely profitable once revenue growth drives significant operating expense (opex) leverage.
That, however, isn’t happening. Year-to-date, operating margins are largely stable year-over-year around 8%, as the gross margin rate and opex rate have both stagnated.
Thus, Zillow’s big three tailwinds are all moderating. That is problematic when you have Z stock trading at a near triple digit forward earnings multiple. Slowing tailwinds converging on big valuation lead to the big sell-off you are seeing in Zillow.
Zillow Stock Is Way Overvalued Here
Without robust user growth, Zillow will have trouble driving robust revenue growth. Without robust revenue growth, Zillow will have a tough time driving huge earnings growth. And, without huge earnings growth, Zillow stock will have a tough time justifying its 80X forward multiple.
Granted, revenues are still expected to be up more than 20% this year. But, in a long-term window, low to mid-single-digit user growth doesn’t imply huge revenue growth. At some point, average revenue per user, which was $7 last year and has been growing at a 17% compounded annual growth rate for the past two years, will max out.
I see Zillow’s business nearing saturation around 200 million users with average revenue per user of $15. I see that happening in roughly 5 years. At that time, I also expect gross margins to stabilize around 93%, and for the operating expense rate to drop to the low-70s, implying operating margins of ~20%.
Even under those aggressive modeling assumptions, though, I still think Zillow can only get to roughly $2.50 in earnings per share in five years. That isn’t enough earnings power to justify today’s $50 price tag.
Even assuming a huge forward multiple of 25 on $2.50 per share, that implies a four-year forward price target for Z stock of just $62.50. Discounting back by 10% per year, that equates to a year-end price target of ~$47.
Thus, to justify a decent return in a long-term window, Z stock should trade well below $50.
Bottom Line on Z Stock
Zillow stock was propped up on huge tailwinds that are now moderating. This moderation is causing a huge valuation reset in the stock. This reset will likely persist until fundamentals create a bottom, which could reasonably happen around in the low to mid $40’s.
As of this writing, Luke Lango did not hold a position in any of the aforementioned securities.