Online real estate platform Zillow Group, Inc. (NASDAQ:Z) has suffered share price weakness after the presentation of the firm’s second-quarter results. I believe the drop in valuation is a strong buying opportunity for long term oriented investors.
Zillow could soon achieve an inflection point (GAAP profitability) and falling interest rates could recharge Zillow’s real estate transaction business. Since shares have recently dropped 20% from their 1-year high, I believe both the valuation as well as the risk profile are favorable for investors that seek an attractive and long term entry into the firm’s shares!
I recommended Zillow in April 2022 as a buy — This Growth Stock Is Still Cheap — after the online real estate platform said it would exit its loss-making homebuying business. Since then, I believe the value proposition has further improved, especially because the company is nearing an inflection point in its business: so far Zillow still loses money on a net income basis, but losses have narrowed in the last two quarters and GAAP profitability is within reach. The company could benefit from a decline in interest rates which could lead to a higher real estate transaction volume on its Zillow platform.
Zillow business model, GAAP profitability could be an inflection point
Zillow owns an online real estate platform that users frequent to buy, sell or rent real estate. The company also offers advertising and other services for which users have to pay an extra fee. Zillow was previously active in buying and selling houses, but the company has closed this business down to its failure to generate profits.
Zillow’s shares sold off after the company reported second quarter earnings, but I believe the market has been overreacting to the firm’s financial results. Zillow generated total revenues of $506M compared to $504M in the year-earlier period. The rentals business during this period saw solid momentum as the segment’s revenues increased 28% year over year to $91M. The biggest segment by far remained the Residential business, which is where Zillow aggregates its marketing and technology solutions for agents and brokers. This business generated $380M in revenues in Q2’23, down 3% year-over-year, and it accounted for a revenue share of 75%.
As was the case in previous quarters as well, Zillow continued to lose money on a net income basis and reported a loss of $35M in the most recent quarter. Since the company’s net losses have narrowed lately, I believe Zillow could slowly move towards GAAP profitability in FY 2024.
Nearing inflection point
Zillow’s real estate platform did not throw off a profit in the last four quarters, but the company nonetheless seems to be on track to achieve positive net income in the short term, which I believe could put the company’s shares back onto investors’ radar screens. In Q4’22, Zillow lost $72M on a net income basis, but losses have since narrowed to $35M in Q2’23. While Zillow lost money ($57M) in the first six months of the year, the real estate platform could soon achieve positive net income… if the company’s trajectory doesn’t deteriorate.
Another upside catalyst
Zillow depends on high real estate transaction volumes in order to generate commissions and capitalize on advertising opportunities. However, with mortgages rates soaring, negatively affecting mortgage demand, housing affordability has dropped to the lowest level since the Financial Crisis in the 2000s. Lower interest rates could result in an uptick in transaction volume on Zillow’s real estate platform. Since inflation has come down a lot in the last year, it is not unreasonable to expect the Federal Reserve to lower interest rates in the short to medium term.
Zillow is expected to grow its earnings 46% next year and earn $1.86 per-share. This gives the real estate platform a FY 2024 P/E ratio of 24.7X. In August, Zillow was valued in excess of 30X forward earnings and given how quickly the market projects Zillow’s earnings to grow, I don’t believe that a 30X is excessive. Valued at 30X forward earnings, Zillow’s fair value might be around $55-56. Considering that shares currently trade at $46, a Zillow investment might generate 20-22% upside potential for investors.
Risks with Zillow
Zillow’s real estate platform could benefit from a general decline in interest rates and improving housing affordability. Mortgage demand is negatively correlated with interest rates, meaning homebuyers’ demand for mortgages decreases during times of high interest rates. As interest rates drop, however, demand for real estate transactions is set to increase, which could provide powerful earnings tailwinds for Zillow’s real estate business. New rate increases would further hurt housing affordability and might lead to a reduction in real estate transactions.
One additional risk that I see with Zillow is that the revenue picture is affected by the performance of the underlying real estate market, meaning Zillow’s financial results could fluctuate considerably in the short term.
I believe Zillow is in a buy-the-drop situation as shares have lost 20% of their value since topping out at $57.19 in August. The real estate platform is nearing GAAP profitability, which I would consider to be a milestone achievement as well as a potential catalyst for Zillow’s shares. A lower-interest world could also fundamentally boost the revenue and earnings prospects of Zillow because lower interest rates are set to reinvigorate demand for mortgages… which in turn should lead to an uptick in real estate transactions.
Given that shares of Zillow Group, Inc. are attractively valued based off of earnings and that the company is moving towards an inflection point (GAAP profitability), I believe the risk profile as well as the valuation are favorable for long term investors!