Ephesians Chapter 1 verse 18 states, "I pray that the eyes of your heart may be enlightened in order that you may know the hope to which he has called you, the riches of his glorious inheritance in His holy people."
I know that God loves me and that the Bible's truths are etched in the past as well as for what is to come. Having hope is paramount to life in my opinion. Without hope, there isn't really anything to sustain life. God's word is full of hope and I find this to be reassuring for all of the circumstances that I have and will face. I am able to have this viewpoint as I believe that God's word is the truth.
For investing, it's very difficult to have an ultimatum of truth. I myself am limited to the degree of what I can interpret due to my imperfections. This is why I have deconstructed my investing management tools into simple and straight forward approaches - Revenue + OCF/FCF = Valuation. The path towards investment returns is always based upon the valuation that the market places upon a company. Using tools to deconstruct margins based on Cash Flows and in certain justifiable cases relying on Revenue is the name of the game, when it comes to valuation.
Today's news from Zillow Group (ZG) was big. The company has decided to entirely exit the iBuying market for its Zillow Offers business segment. This has equated to Zillow laying off 25% of its workforce. The gist of this is interesting as Zillow has stated that the iBuying market is not as lucrative of a business opportunity over the long-term, justifying this "difficult" decision. This pits the viability of the iBuying business model directly against Opendoor Technologies (OPEN), the market leader.
Zillow had a sequence of events unfold that led to today's earnings announcement bomb-shell. First, the company disclosed that it was having labor issues in employing the capacity needed to prepare purchased homes for sale. This was further illuminated as Zillow disclosed the purchase of 9,680 homes during Q3 2021 and only just over 3,000 homes sold, below expectations. In short, an inability to hire enough employees to convert purchased homes into sales was the culprit for missing former guidance.
Next, Bloomberg came out with a report that Zillow was looking to offload around 7,000 homes for approximately $2.8 billion. This is now confirmed as Zillow has fully disclosed that it is exiting the iBuying business so it does not prefer to de-stock or liquidate a majority of its current inventory, standing at just below 9,800 homes.
Before I continue, I think it's prudent to divulge Zillow's justification for exiting the iBuying market with their direct remarks.
And here's some color on the pivot that will be less risky and yield strong investor returns for Zillow 2.0 moving forward per Zillow's remarks.
It's clear that Zillow's core justification is predicated financial impacts, namely on margins and the Balance Sheet, as well as Cash Flows.
Comparing Zillow with Opendoor, we get the following GM comparison:
I've highlighted Zillow's YTD as it includes the Q3 2021 information. This isn't apples-to-apples against Opendoor's Q2 2021 information, and Zillow's GM was at 8.6% comparatively in Q2. So in essence, Zillow was seeing a similar trend heading into Q3 with strong GM expansion. The severe contraction in GM performance is now clearly an issue associated with Zillow's inability to sell more homes versus what they purchased.
As is clear, Zillow has been chasing Opendoor for some time now and the pressure, in my opinion has finally caught up with them. Once Zillow offloads the 7,000 or so homes from its inventory, we should expect to see a drop in its iBuyer homes for sale, versus the current uptrend. From this information, it appears that Zillow will be allowing the remaining listed homes to be liquidated digitally.
The other key component is the Balance Sheet. Zillow witnessed a massive shift in increased debt to finance the iBuying segment, while it was unable to successfully execute on turning over homes to generate more Revenue during Q3.
This has led to a first where Zillow is now in a Net Debt position, including a 1.2 times Debt to Inventory position. Opendoor as of Q2 was in a 0.84 times position, again an outcome of Zillow's inability to sell enough purchased homes in Q3, which was largely attributed to the labor shortage issues.
Looking to the highlighted areas, the hit on OCF from inventory home purchases exponentially increased during Q3's 9,680 homes purchased for Zillow. Concurrently, every other key metric, OCF, FCF, and Adjusted FCF were all negatively impacted.
As a reminder here, I am using an Adjusted FCF metric to value iBuying businesses as I view the Inventory and directly correlated debt on the Balance Sheet as offsetting components for true FCF. This is justified assuming an approximately 1:1 relationship between the two. All Cash Flows outside of these elements is what I consider to be the appropriate way to value the business, so on the Last Twelve Month, LTM period, Zillow's Adjusted FCF stood at -$324 million.
Opendoor is also in a similar position, burning Adjusted FCF on an LTM basis at -$693 million as of Q2. I don't anticipate Opendoor generating positive Adjusted FCF before 2024, and this area remains unclear as to how scalability and GM performance will lead to a positive Adjusted FCF outcome. As such, while Adjusted FCF is the key to unlocking mid-term valuation, EV/Revenue is the only way to value these businesses today.
For me the question is what happened with Zillow? They were seeing improving GMs in a similar trend as Opendoor. I recall in an earnings call a few quarters back that Zillow had thrown out a percentage number of around 60% of Zillow Offers occurring in a fully digital fashion. In my opinion this placed Zillow in a tough situation pivoting to the iBuying market only partially, while still operating separate IMT and Mortgage business segments. I believe that Zillow's core issue was juggling between selling purchased homes physically and digitally, and eventually it caught up with them, notably on their inability to grow GMs. I view this as an execution failure, predominantly based on miss-management of human capital to successfully grow its iBuying business. As I have written on before, I see many legacy businesses looking to pivot facing high risks that typically don't get much scrutiny. Zillow is a case-in-point.
The short-term is going to be volatile as Zillow's now public remarks that iBuying is not in their best interest based on volatility, and earnings and Balance Sheet risks, will lead to more scrutiny with Opendoor. Since last Friday and including after-hours, Zillow's SP is down 28%, while Opendoor's is down 10% (nearly 15% today alone). After-hours saw Zillow dropping 11.5%, while Opendoor was up nearly 4%. Opendoor has inversely traded for the most part as Zillow has announced negative news on its Zillow Offers segment.
So how does Opendoor win? For me, the key ingredients are beating Revenue and GM estimates, while maintaining their inventory/direct debt ratio at or below 1:1.
Analyst estimates have continued to increase for 2021 and 2022. My financial model now finds itself on the low-end conservative side. I will be paying attention to how adjustments occur leading up to Opendoor's earnings date. I don't think Wallstreet has the best read on things so it may take some time to truly understand how this all unfolds.
Zillow's focus on digital services for the 226 million or so average monthly users is not an admission that iBuying will not continue to grow substantially. It is more of a continued focus on Zillow's current platform, namely the Z-Estimate as the underpinning foundation, to build upon. I view this as a very conservative move, and long-term as a potential major miss-step for Zillow. iBuying companies like Opendoor will not only purchase and sell homes. In fact, my opinion is that as iBuying scales further, it will inevitably look to compete directly on all of the current services Zillow offers. In essence, if iBuying wins long-term, Zillow may have placed their entire business model at risk of obsolescence. I always assumed that Zillow's iBuying long-term goal would be to consolidate its services into one platform over time. Clearly, Zillow is fixated on a bundle of services being their digital future.
As iBuying is still a nascent market in a vast real estate TAM/SAM, it will still take some time to see how Opendoor continues to execute. Investors need to keep an eye on the key metrics, beyond the simple approach of earnings. To put it simply, if a business model can use leverage to grow real estate inventory, while generating Net Cash, it is very similar to a bank with respect to offsetting and directly correlated Assets and Liabilities. If Opendoor eventually generates an Adjusted FCF it will be in the driver's seat.
I initially chose Opendoor over Zillow based solely on the iBuying market opportunity with Opendoor being the market leader. So far it has been a great call, but there's a lot more to accomplish for Opendoor before I will dare claim any victory. Next week's earnings report will be one of Opendoor's most important. Only then will we see clearly on Opendoor's Q3 comparable performance.