Is Zillow's Plunge a Value Opportunity? - Stockxpo - Grow more with Investors, Traders, Analyst and Research

Is Zillow’s Plunge a Value Opportunity?

On Tuesday, American online real estate marketplace Zillow Group Inc. (

ZG, Financial) made an announcement that shocked investors. It plans to exit its homebuying business entirely, cutting 25% of its workforce in the process, as it foresees increased dangerous unpredictability in housing prices going forward.

The news caused Zillow’s stock to fall more than 10% throughout the day’s trading. It dropped an additional 7% in after-hours trading before plummeting more than 22% on Wednesday to trade around $65.88. The price hasn’t been this low since August of 2020.

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Despite market panic over the announcement, Zillow has good reason to exit its homebuying business at this point. Billions of investment dollars have been pouring into an overheated housing market the past couple of years as investors seek to take advantage of rising home prices. As more investor-flipped houses come on the market to buy or rent, mortgage rates seem set to increase and inflation runs rampant, which seems like a recipe for unpredictability going forward.

Zillow could thus be making the right decision in mitigating its risk by getting out of the homebuying market while it can. If that’s the case, does the stock’s plunge represent a value opportunity, or could the company’s warning about the upcoming troubles of the housing market mean the stock has further left to fall?

The ill-fated home-flipping venture

Zillow started its homebuying venture in 2018, when it got into the “iBuying business.” With the iBuying process, tech companies with deep pockets like Zillow use proprietary algorithms to buy homes at a discount, make renovations and (hopefully) sell them for a gain.

However, most people who have been involved in flipping a home – even those who do it for a living and love it – will tell you that it’s not as easy as it sounds. The golden rule is to be able to reliably predict that you can buy a home and renovate it for about 70% of what you can eventually sell it for. The short-termism of this strategy makes this even more difficult, since home-flippers are typically relying on situations where sellers give up their homes at a bargain due to not wanting to deal with the headache of repairs.

Zillow was relying on its Zestimate to help lower the costs associated with appraising home values as well as narrow the margin of safety needed in order to reliably turn a profit from flipping homes. However, as the company’s widening net loss shows, this approach hasn’t worked out as planned.

The Zestimate falls short (or long)

On Oct. 18, Zillow began winding down its homebuying business, announcing that its instant-buying business, Zillow Offers, would stop buying homes for the rest of the year. During the two weeks that followed, Zillow listed nearly 1,000 of the homes it had bought in its five biggest markets, with 64% of them marked for less than the company paid for them.

With the announcement that the company plans to shutter its homebuying business for good, the question many are asking is, how reliable is the Zestimate, which is Zillow’s automated estimate of a home’s value?

Even though the estimate is certainly not always accurate, and homes frequently sell for far higher or lower than their Zestimate, it has become frequently used by sellers and buyers to get an idea of what they should bid. Sellers will sometimes hold out for a bid that is at least as high as the Zestimate, throwing the number in the faces of potential buyers who offer less.

The reality is that something is only worth what people are willing to pay for it, however, and that number is incredibly difficult to accurately predict using a click-based algorithm alone. Just because a lot of people are looking at houses in an area doesn’t mean those homes will always increase in value by a predetermined amount.

Zillow is learning this the hard way. The red-hot housing market made flipping look like easy money in 2020, and investors rushed in to snap up properties accordingly. Indeed, just like the stock market, when housing prices are on a strong bull run, it’s easy to confuse the power of the bull market with a sound business strategy. Now that the tides are starting to turn, though, it seems that Zillow’s margin of safety isn’t enough. No longer finding the business profitable, the company needs to exit before it can book even more losses.

The housing market could begin losing steam

Zillow’s failure in the house-flipping business could be an indicator that the housing market is beginning to lose steam. For the past couple of years, the combination of easy monetary policy, rising wages and the ever-widening housing shortage has pushed prices steadily higher. Just about every factor affecting home prices was bullish, minus the loss of jobs that came about due to the initial onset of the Covid-19 pandemic.

However, if even one of these factors were to reverse direction, it could exert downward pressure on housing prices. The Federal Reserve backing off on its easy-money policies will result in mortgage rates rising again, meaning people will be able to get less house for their money. If wages don’t grow faster than inflation, then consumers’ buying power will decrease as well. An uptick in homebuilding or a flood of investor-flipped homes coming on the market could ease the undersupply pressures, giving buyers more options.

In this situation, it seems possible that Zillow is fulfilling the same role as the canary in the mine. Its higher-risk business model makes it more vulnerable to an industry downturn, so a failure in its business could spell trouble for the rest of the housing market.

Valuation

Even at a price-earnings ratio of 113.57, the GuruFocus Value chart assigns Zillow a rating of significantly undervalued. The stock has pulled back more than 50% since the beginning of 2021.

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However, we have to look at this in the context of what the GF Value measures. It is based on historical valuation multiples, past returns and estimates of future business performance. Zillow has now cut a portion of its business that analysts had high hopes for, eliminating a quarter of its workforce in the process. Its historical returns were stellar as investors bid up tech stocks and housing stocks in 2020. Its historical earnings multiples have also been far higher in the short history of its profitability, with the price-earnings ratio surpassing 800 in early 2021.

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When Zillow developed its Zestimate, it had high hopes for the number, and the goal for it was to eventually be able to accurately predict the market price for all homes. If it could truly achieve this goal, it might be worth its high earnings multiples.

However, as the failure of its homebuying business shows, its algorithm still has a long way to go. In the meantime, the cyclicality of the housing market poses too much of a risk for Zillow to really take advantage and monetize it in the way the company and investors were hoping.

It seems that Zillow has seen the proverbial writing on the wall in this case. While it’s possible the company could be wrong about the direction of the housing market, it has sacrificed a quarter of its business on a bet that housing prices are probably going to go down in the near future, or at least that they won’t rise enough to make house flipping worthwhile. That could mean that a further drop in the stock’s valuation is in the cards.

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