Zillow: Where's The Money? Where's The Value?

By David Butler for Seeking Alpha

What’s up with Zillow?

Something that drives me nuts about Zillow Group (NASDAQ:Z) is how long it is taking for it to produce meaningful profits. You have a stock that until the recent drama over home valuation lawsuits was trading at over $50 a share. Ironically, the company has reported consistent losses. The second quarter of 2017 showed signs of expenses finally nearing a balance with revenues. Will it all change in the third quarter? If so, will it be enough to justify the stock’s valuation? I have concerns. For one, its business model is easily replicated. The company has created over $300 million of debt, and the stock is expensive.

Ignoring this year’s drama over lawsuits, Zillow’s moves have shaken the real estate world. On top of that, its revenue growth has been impressive. Between 2012 and 2016, revenues have increased more than 800% to $846.59 million. That said, it just hasn’t proven super profitable. In that same time frame, the company lost around $400 million. Shares outstanding have subsequently skyrocketed to 185.44 million in order to raise capital. That’s roughly 6x the number in 2012. The company reported $6.81 million in earnings last September, and hasn’t delivered positive numbers since.

Q2’17 was a big improvement. Not only did Zillow’s revenues improve by 28% year over year, but also its net loss drastically improved to $21.8 million versus $156.1 million in 2016. Alas, despite a record $266.9 million in business, Zillow Group found no profits. The cause is an aptitude for increasing costs. While the cost of goods sold actually decreased for the quarter, Zillow’s SG&A expenses expanded 19.37% quarter to quarter. That’s about double the rate of the company’s actual sales growth.

Again, I would point out that year over year the numbers are still a drastic improvement. SG&A expenses decreased 35% to $239.95 million. So if I was to simplify my take on this whole story, Zillow has drastically improved its big picture finances, but there are still some tweaks that need to be made.

Will the expensive past yield future results?

I myself still feel the stock is a bit overpriced considering the lack of real earnings backing it up. As I said before, SG&A expenses are still outgrowing revenues on a percentage rate basis. If Zillow turns a profit this quarter, I doubt it’s going to create a price to earnings ratio justifying $40. Barring a severely blunt end to what has been a very long bull market (that’s right, it could very well happen), I expect Zillow’s third-quarter results will have a significant impact on which direction the stock carries throughout the rest of the year. This is all about morale. Investors have waited quite a few years to see some significant returns on investment.

All they’ve actually gotten thus far is a severe dilution of their stock. In turn it has diminished their cut of the much anticipated earnings. Couple in the bearish weight from lawsuit talk over insulting housing valuations and Zillow really needs a win. Personally, I think the only thing that has held the stock up was its surprising second quarter. The record-setting quarter that outperformed many estimates has provided hope of a profitable third act for the year. The exponential revenue growth is an encouraging sign. Zillow Group’s own outlook has net income for the third quarter ranging broadly between $2.25 million and $7.25 million. God be with it if it comes up in the red again after tugging at our heart strings.

Zillow as an investment

Like most things, real estate is certainly merging with online business. To that end, I think Zillow has a bright future. When you consider the sheer increases in revenue, it’s clear there’s a good business here. That said, I’m not sure now is the time to take the plunge. The stock is expensive. Even if the company hits on the higher end of that net income projection, $7.5 million doesn’t deliver much in terms of earnings per share when the company is projecting diluted shares between 196 million and 198 million. $0.03 per share does not justify a $40 price tag. Furthermore, the full-year outlook is still in red territory with 2017 net income projections at a loss of $25-15 million.

If you couple in the very high nature of the stock market right now, I think Zillow has room to fall. Let’s be honest, many of these mainly online-based tech companies have very elevated valuations relative to their actual earnings performance. If this bull market does break, and we finally experience some widespread downside, I see these types of stocks as being the first to fall.

From a less dramatic viewpoint, Zillow’s stock has been bearish for the past three months. A profitable third quarter might bolster prices in a reactive manner, but the projected earnings aren’t enough to justify current prices. I will consider taking a long-term position in Zillow Group around $20-25 a share. It doesn’t make sense to pay $40 for a company that will still be in the red for 2017. Furthermore, its model is easily replicated.

There are hundreds of real estate brokerages out there that probably don’t like seeing commissions being spread into paying for Zillow advertising. Who’s to say that more won’t follow the Redfin (NASDAQ:RDFN) approach and start pushing their brokerage work online? Keller Williams certainly has the scale and capacity to do it. CoStar Group (NASDAQ:CSGP) is already doing it with Apartments.com as well as other ventures. CoStar is also priced very high, but it is at least putting up profits.

Overall, I like Zillow’s business. I just want to see a little cost management moving forward in order to justify the stock price.

Summary

Zillow Group has been getting a little attention as expenses and revenues finally start to edge toward a balance.

The third-quarter outlook involves positive net income. That said, the figures don't seem to justify the stock price.

The company has competitors forming through normal brokerages, and other players like Apartments.com. It does not make sense to me to pay anywhere near $40 a share for this stock.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.