Zillow (NASDAQ:ZG, NASDAQ:Z) has a very profitable internet and media business. It also has a very healthy balance sheet, with $2.42 billion in cash and only $1.54 billion in long-term debt. But Zillow stock has fallen this year as the company moved headstrong into a new line of business – buying houses and flipping them.
So far this year, even after the past two days’ massive gains, the stock is still down 43.7% from its 52-week peak. And that peak was just about a month ago in late February.
My point is that there is something more going on here than just the general market downturn from the coronavirus impact.
Move into Home Flipping has Been A Disaster
The move into home flipping and trading mortgages is taking the company in new directions that are unprofitable. The market is not sure that is such a great idea.
For example, on Feb. 19, 2020, Zillow reported in its press release that the Q4 2019 adjusted EBITDA for the Homes segment was negative. It lost $82.5 million flipping houses in Q4 in that division. That was based on $603.2 million in revenue.
So you can see that the margin in Q4 was terrible. In fact, the numbers for all of 2019 in the Homes division were just as bad. Zillow lost $241.3 million on revenues of $1.37 billion during 2019 in that division.
This is the first year that Zillow went across the country making offers on residential homes. They are now in 23 markets, by 2019 year-end, and have since entered one more. These include Los Angeles, the largest real estate market.
Zillow Doesn’t Care – Scale Cures Everything
But Zillow doesn’t seem to care. Forget the fact that the market is at a peak. Forget that interest rates are at all-time lows. Damn the torpedos, and full speed ahead.
Zillow believes that scale cures everything. They just have to make it bigger. Here is what CEO Rich Barton says:
“Once we achieve scale, we expect to deliver an average return on homes sold before interest expense of 400 to 500 basis points per home, and to achieve a Homes segment Adjusted EBITDA margin of 200 to 300 basis points.”
But if you read further, here is what is really going to deliver the profits:
“As a reminder, these estimates exclude expected additional earnings from adjacent business lines, such as title and escrow and mortgage originations.”
I guess the home flipping is a loss leader for the revenue from title and mortgage fees. That is a really interesting way of doing business. Maybe it will work and maybe it won’t.
Strategy of Buying at the Peak
Maybe. But good luck persuading long-term holders of Zillow stock that this will work. Any kind of extended recession will ruin this plan.
Meanwhile, the coronavirus pandemic has stepped in: Zillow just announced that it is suspending its home buying. On March 23, 2020, Zillow said it would “pause” buying in Zillow Offers “in response to COVID-19 and market uncertainty.”
Granted, the state requirements that all activity be stopped in a number of states was the catalyst. But I suspect that this couldn’t have come at a better time for Zillow. Now maybe the company will reassess its obsession with home buying.
What to Do With Zillow Stock?
The company’s core business, selling real-estate-related ads, is extremely profitable. Perhaps, if the company can expand that line of revenue the stock has a chance of recovering quickly.
Look to see if management has changed its mind about moving into unprofitable business lines. If not, be aware that Zillow stock may take longer to reach its previous highs.