Ostensibly, the Zillow Group (NYSE:ZG) looks like a solid company, and Zillow stock looks like a good long term holding.
The company is the leading online real estate marketplace at a time when everything in the world is pivoting from offline to online.
Zillow has very little competition in the online channel (since they’ve acquired all of their competition), huge reach (which creates network effects, since Zillow is a marketplace of buyers and sellers), and a ton of home browsing data (which constitutes a massive competitive advantage through smarter search and price estimation algorithms).
At the same time, the housing market is supported by solid fundamentals today. You have low-interest rates, a full labor market, high consumer confidence, and big wage gains. The personal savings rate in the U.S. is also very high, while the homeownership rate is relatively low. Thus, easing trade tensions and improving economic conditions could propel non-homeowners with big savings to become homeowners in 2020.
That should provide strong tailwinds for Zillow’s steadily-growing advertising business, as well as its rapidly expanding home flipping business.
Net net, most things look good for Zillow right now. So, buy Zillow stock, right?
Not so fast. Most of the aforementioned has been true for Zillow stock for the past several years. Yet, Zillow hasn’t gone anywhere in over three years (this was a $40 stock back in mid-2016).
Why the sideways trading in Zillow stock? Profitability issues. Specifically, Zillow isn’t profitable, nor does it project to strike a profit anytime soon. So long as this remains true, ZG stock will struggle to hold onto gains.
Zillow Has a Profit Problem
There’s one huge problem with Zillow, and that one huge problem is profitability.
Long story short, Zillow has a bunch of rapidly growing businesses. There’s the advertising business, which has been growing at a high single-digit pace all year long. There’s the faster-growing mortgage business, which is up 40% year-over-year so far in 2019. And, of course, there’s the new home flipping business, which has gone from a $10 million quarterly revenue business in late 2018, to a $380 million quarterly revenue business in late 2019.
Put all that together, and Zillow’s revenues are up nearly 90% year-to-date.
But, only one of those businesses (the advertising business) is profitable on an adjusted EBITDA (earnings before interest, taxes, depreciation, and amortization) basis. The mortgage and home flipping businesses each run huge adjusted EBITDA losses. Meanwhile, the drivers of the company’s EBITDA profitability are quasi-real expenses, like stock compensation, depreciation and amortization, and interest. When you factor those back in, none of Zillow’s businesses are profitable.
Of course, one can argue that profitability will come. Specifically, the ad business will improve its margin profile with scale, because it does operate at 90% gross margins.
Meanwhile, the mortgage and home flipping businesses are nascent businesses that, once mature, will have significantly better profit margins.
Sure, that all may be true. But, how long will it be until this company strikes a profit? And how big will those profits be? It will take too long, and the profits will be too small, to warrant the current price tag on Zillow.
Zillow Stock Is Richly Valued
When you look at the numbers underlying Zillow, it becomes obvious that things don’t add up.
Revenues this year are expected to be over $2.6 billion, with pretty much all of the gains driven by the hugely unprofitable home flipping business. This home-flipping business is expected to keep growing at a rapid rate over the next several years, while the profitable ad business is expected to grow at a much more tepid rate.
As such, even though revenues are expected to rise 75% in 2020 to $4.7 billion and another 55% in 2021 to $7.2 billion, analysts project Zillow’s EBITDA margins to be only narrowly higher by 2021, and for the company to still report a huge net loss per share, according to YCharts data.
In other words, although revenues are expected to keep roaring higher, profits aren’t expected to join the party. Instead, Zillow’s fiscal 2021 loss per share is estimated to be nearly the exact same as its 2019 loss per share of 60 cents.
There is a light at the end of the tunnel here. As the home-flipping business cools on its rapid expansion trajectory, expense growth will moderate, and margins will meaningfully improve. This should drive overall margin improvement, and eventually, push Zillow into profitable territory.
But, that light at the end of the tunnel isn’t that bright. Even assuming robust 40% annualized revenue growth in 2025 and several hundred basis points of profit margin expansion, my modeling suggests that this company will only do about $3.75 in earnings per share in 2025. Based on a market-average 16-times forward multiple and a 10% annual discount rate, that equates to just a $40 2019 price target for Zillow.
Bottom Line on Zillow Stock
Ostensibly, Zillow looks like a great investment. But, under the hood, this company has some major profitability issues. These profitability issues have kept shares stuck in neutral for the past three years. The unfortunate reality is that, so long as these profitability issues hang around, Zillow stock will continue to trade sideways.
As of this writing, Luke Lango did not hold a position in any of the aforementioned securities.
