This article is excerpted from Tom Yeung’s Profit & Protection newsletter dated Aug. 12, 2022. To make sure you don’t miss any of Tom’s picks, subscribe to his mailing list here.
“Never get high on your own supply.”
“Don’t use what you deal.”
Anyone who’s watched an episode of Breaking Bad or The Wire will have seen some version of this street-wise advice before.
But don’t try telling corporate America that.
In the years leading up to the financial crisis, bank bosses would start dabbling in the products they sold to customers. Subprime mortgages… Commodity futures… credit default swaps… These “prop trading” desks seemed to ask, “if our customers are making so much money from our products, why can’t we?”
Zillow Casts a Dark Shadow Over Opendoor’s Future
The same forces seemed to draw Zillow (NASDAQ:ZG) into the same trap. In 2018, the online real estate aggregator decided it could make more money by using its pricing algorithm to trade houses…
…and $880 million of losses later, and it too is realizing why I rarely recommend companies that speculate on their own products. When a business specializes in market-making, alarm bells should ring if it starts “getting high off its own supply.”
But what about Opendoor (NASDAQ:OPEN), a company that specializes in trading these assets? Is it in the same boat as the prop traders that brought down Zillow’s iBuying program?
The Trouble with Opendoor’s Business
Opendoor is a real estate iBuying firm that aims to streamline the residential real estate business. In 2021, the company sold over 21,000 homes and generated $8 billion in revenue.
By all growth metrics, this company should look like a slam-dunk winner. The real estate market is notorious for its inefficiencies. On average, buyers take 30-45 days to close on a house, and Opendoor provides an alternative that can close homes in as little as 14 days.
For home buyers, the firm also provides significant savings. DIY buyers can tour homes without agents, saving thousands on broker fees. No surprise OPEN has notched a 83% compound growth rate since 2017.
Yet, not all is well with the growing startup, as its “C-grade” quality score shows.
That’s because OPEN operates much like Carvana (NYSE:CVNA) in autos today, or prop-trading banks in subprime mortgages in 2007:
It gets high on its own supply.
In Q2 2022, Opendoor logged $6.6 billion of real estate on its books — about nine months of inventory. These houses, in turn, are funded by about $6.5 billion in asset-backed debt financing. It’s a powder keg of leverage that’s ready to go off.
As good as its pricing algorithms are, OPEN’s balance sheets will not escape a housing slump.
All else equal, a 10% gain in home prices would raise the firm’s equity value by $660 million, while a 10% loss would do the opposite. You don’t have to be a real estate speculator to know that such high loan-to-value ratios is a recipe for disaster.
A Black Swan Event Hiding in Plain Sight?
These risks have not gone unnoticed entirely. Since November, Opendoor’s shares have lost three-quarters of their value as investors have reconsidered the company’s leveraged positions.
If real estate prices are up 17.5% in a year and your company still loses $274 million, something is clearly wrong.
But Opendoor’s management seems oblivious to such fears. Its annual report highlights interest rate risk as its only significant concern; management ignores the price risk of its 13,000-home inventory. And the firm doesn’t publish any stress-test reports – a major red flag for a company that owns almost as many finished houses as America’s largest homebuilder D R Horton (NYSE:DHI).
These are clear red flags. A crash in housing prices will reduce the carrying value of OPEN’s inventory. And such a drop will have knock-on effects on the firm’s finances. If the company’s equity base shrinks, that could trigger loan covenants, causing even more degradations in the firm’s credit, and so on.
It should surprise no one that OPEN’s 2026 bonds trade at 64 cents on the dollar.
What to Do with OPEN Stock?
None of this means Opendoor can’t succeed. Mature companies from commodity giant Glencore (OTCMKTS:GLNCY) to Japanese conglomerate Marubeni (OTCMKTS:MARUY) have long used their commanding market positions to earn billions from prop trading. And Opendoor’s position as a real estate marketplace may one day turn it into an “Amazon of real estate.”
But the promising company doesn’t make the core Profit & Protection “buy” list for its financial risk.
Instead, two tech-focused real estate firms make the list. One is already up 40% since I recommended it last month. It’s an asset-light real estate brokerage that I strongly recommended as a tactical play on near-term housing prices.
The other company is a longer-term strategic investment that’s up 8%. Buyers still have plenty of time to get in on this slow-burner.
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Take Opendoor’s Financials with a Grain of Salt
Scan OPEN’s financial records, and investors will quickly see a series of red flags.
Assumptions that interest expense will remain at 1%…
… A growth rate that seems too good to be true…
… A $62 million fine from the FTC over “deceptive” marketing…
The list goes on.
Sometimes, startups can overcome these hurdles by sheer force of will. Companies from Amazon (NASDAQ:AMZN) to Tesla (NASDAQ:TSLA) adopted a “fake it ‘til you make it” attitude to raise billions in cheap capital and thrive.
But often, these types of companies go bankrupt like Pets.com or Henrik Fisker’s first electric vehicle company.
Now, InvestorPlace’s Eric Fry has assembled a list of 25 other popular stocks that he believes are “doomed firms” that are “all but assured to underperform in the next few years.” And it’s part of a presentation you should see today.
With black swan events seeming to happen more often than ever, it’s important for long-term investors to play good defense as well.
Tom Yeung is the editor of Profit & Protection, a free e-letter about investing to profit in good times and protecting gains during the bad. To join Profit & Protection — and claim a free copy of Tom’s latest report — go here to sign up for free!
