SITALWeek: Zillow Disrupts Itself

Stuff I thought about last week: Zillow and Rich Barton’s Big Hairy Audacious Goal to bring his “power to the people” economics to home buying

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“I have a particular penchant for and attraction to big swings. And we are really in the process of remaking Zillow Group right now and formulating a new mission, one where we're looking at the sky, looking at the moon and saying, ‘We want to land there. We want to walk on that thing.’ It takes a really big, hairy, audacious goal, BHAG, to get an organization to transform itself.” - Rich Barton on Zillow’s Q4 2018 earnings call this last week.

Zillow is undertaking what will likely be one of the largest business model pivots I will see a public company make in my career - there is a reasonable probability that it results in only one of two possible binary outcomes: bankruptcy or a 10x increase in value! I am certainly rooting for the 10x increase, but there is a scenario where this shift to a capital-heavy, cyclical business model from a marketplace or media model crashes into an economic slowdown or housing crisis and bankrupts Zillow and other competitors. The question at stake is this: can a high-friction, real world transaction take place in a digital marketplace model? Or, as Rich put it, can ZIllow “Uberize” the home selling experience? The answer from my perspective is: I don’t know yet, but it’s worth figuring out which questions to ask in order to understand why this would succeed or fail. There has been a lot of activity attempting to innovate in the real estate business over the last couple of years as startups like Open Door and established players like Zillow and Redfin attempt to create liquid transactions for selling your house - immediate offers for a predetermined value - known as the iBuyer business. Zillow is currently an advertising and media company effectively selling leads for real estate agents to find buyers and sellers while providing information like the Zestimate home value estimate for consumers. With the co-founder of Zillow, Rich Barton, returning to the CEO role, the company is boldly moving toward the transaction itself, while still trying to keep agents in the revenue model by using them for selling houses they acquire.

How much would you pay to sell your house? The answer might not be what you think:

When I’ve looked at this concept in the past, I was struck by the counter-intuitive conclusion that the 5-6% commission to sell a house might be high in some cases, but might also be low in other cases, i.e., people might be willing to pay more than 5-6% to get liquidity in their house for a variety of reasons. So, it’s possible that the blended commission is still 5-6% supporting an approximate $90B annual revenue opportunity in the US. Increased liquidity could also drive increased turnover as people are able to get closer to their workplace, trade up with less risk, etc. Consumers should be willing to pay for the benefit of liquidity - the overall addressable market then could be well into the hundreds of billions of dollars annually.

What are the current strategic problems I see with Zillow’s business model, and why are they buying and selling houses direct instead of building an iBuyer marketplace?

I’ve criticized Zillow in the past for creating a power law in the real estate agent business - they effectively created super agents or power agents that were Zillow-savvy who created teams of subordinate agents - recreating the brokerage model for mid and high priced homes. Rich is famous for his “power to the people” democratization business models like Expedia, but this power-law Zillow created for agents didn’t seem to quite fit in with the leveling of the playing field Rich often promoted - instead it just flipped the power dynamics for agents. A 2nd criticism I’ve had of Zillow’s core agent ads business is the cost of marketing spend required to maintain the consumer side of their marketplace. One of the problems with low frequency transactions like cars or homes, which take place on average every 5-10 years, is that you need to constantly keep your brand relevant to consumers, which means a heavy advertising and marketing spend just to remind people you exist. This low frequency and high advertising combination makes a media business like Zillow lower margin and less attractive long term. Lastly, a criticism I raised with the company last year as they began this pivot into iBuying was “why aren’t you creating a marketplace for regional and national investors that want to buy/sell homes instead of doing this as a vertically integrated buyer yourself?” Home buying and selling can be a very location-specific business with a high degree of local knowledge needed. I didn’t feel comfortable with the idea of taking balance sheet and housing cycle risk instead of leveraging Zillow’s strong consumer brand into a transaction marketplace. On the conference call last week, Zillow indicated they still believe iBuying should be done by them directly instead of as a multi-sided marketplace model - I remain unconvinced on this point, but remain open minded about it.

Who will own the network effect for the home buying and selling transaction and why?

Another question I have is: what would cause home buying to be winner-takes-all (or winner-takes-most), like many other traditional industries that have been digitized and impacted by increased transparency in the Information Age? Is there too much friction and market-by-market heterogeneity in the housing sector to create a power law network effect that hits escape velocity for buying homes? For example, why are there seemingly dozens of marketplaces for buying and selling cars instead of one winner? Cars are a high friction transaction, but lower friction than moving from house to house - why hasn’t a marketplace model hit escape velocity for the automobile asset class - is it a bad comparison, or are there lessons to be learned from that market? Rich has referenced Netflix’s (Rich is a board member at Netflix as well) shift to streaming as an analogy for Zillow’s shift to iBuying. One of the reasons Netflix has over 100 million subscribers today (and I think they will have 500M-1B or globally) is the data network effect they garnered when they hit around 20M streaming subscribers, which created a virtuous circle flywheel of viewing habits that allowed them to invest intelligently in content to grow more subs, to get more data, to invest in more content, to grow more subs, etc. Zillow has great data on home transactions already - all of which is public information, but it’s possible owning the transaction gives them more granular data, and sooner, than they could otherwise obtain it.

ROOTMO - leveraging a Resilient business to build new Optionality

A pattern we look for in investments is companies that can take a Resilient core business and layer on significant out-of-the-money Optionality to it (we call this ROOTMO: Resilience with Out-of-the-Money Optionality). Zillow has Resilience today with their core agent ads business, but will they risk any of that Resilience in this model shift? In other words, is this Optionality to transform the entire home selling experience going to risk the FCF that is funding it? Zillow has attempted to build Optionality in the past, with rentals, mortgages, and home decorating, with limited success. However, mortgages are of course another way to interject themselves into the transaction and that’s an important part of this strategy shift for the company. What Rich Barton is attempting with Zillow is precisely what I described in my piece last week on what happens when disruptors face their own disruption - this is exactly the kind of thinking and risk taking I like to see technology companies undertake even when they are public and under investor scrutiny! If the shift to iBuying represents a long term threat to Zillow’s core, Resilient advertising, and media business, then, not only is the decision to pivot fully into the transactional business model the right move, it’s a gamble that needs to be undertaken quickly and at all costs.

The questions I am asking:

I think the world of Rich and everyone at Zillow and I want them to be successful with this transition - I am rooting enthusiastically for Rich and Zillow to be correct with this huge business pivot. Although I have not discussed Redfin much in this post, I also like the more conservative democratization approach that Glenn is taking at the technology-driven brokerage Redfin. I am rooting hard for Glenn and Redfin as well. You could see a situation where there are multiple marketplaces for home transactions - one winner for homes that are around the median price or cheaper and another for higher-end homes (where Zillow’s advertising business has traditionally been of higher value while Redfin has traditionally been strong around the median home price market). If we zoom out and try to generalize the problem and the solution, we have a $90B annual tariff on transacting a house today in the US. Is that tariff too high? Whenever we see the pattern of information transparency causing a tariff to be reduced we pay close attention - often that creates a tidal wave shift of positive feedback loops. Should that tariff become a gradient of 1% to 10% instead of an average 5-6%? Will a reduction in friction and increase in liquidity drive velocity and better outcomes for all? Should the risk of home buying and selling shift from the home owner to a financial intermediary model such as Zillow, Open Door, or other iBuyer? If all of this is the right strategy shift for the industry, will there be a winner-takes-all (or most) network effect created? If so, what are the underpinnings of that network effect - data, liquidity, brand, trust, access to capital, etc.? Would a major acquisition like Zillow buying Open Door accelerate and bolster a network effect assuring success? I am very excited to watch this play out over the next decade and I have nothing but wishes of luck and success to the democratizers of the home transaction!

I started with a quote from Rich here and I’ll finish with his closing remarks from their conference call which sums it all up nicely:

“As we've discussed, we are in the middle of a critical transformation that is reshaping our company and redefining the rules of real estate as we know them. By moving into transactions, Zillow Group will cover the entire consumer home shopping funnel top to bottom, giving today's on-demand consumers a full spectrum of options to shop, engage, transact on their terms. By transitioning our relationship with agents from advertisers to real partners, we better align our mutual goals and incentives and cooperate to delight our shared customers. This all makes us well positioned to unstick those shoppers ready to follow their dreams and getting to a place they love and can afford.

Finally, just to restate, I know Zillow Group's aggressive expansion has not just evolved our business model, it's affected your Excel models. We've added a high-revenue, low-margin business that requires large investment and distributed operations to our proven, high-margin media business that you know and love. And that can be unsettling, especially when our execution on the core business has been bumpy. It was unsettling for us, too, initially, but we came to believe the prize was quite large, and further, it was a strategic necessity. This is where consumers are heading, and they'll ultimately get what they want with or without us. We decided to lead them there. Can you imagine if Netflix had just ignored streaming?”

You can probably tell I'm excited. I hope you are, too. Thank you in advance for keeping an open mind and for giving us a chance to show you what we see. We value your counsel, and I look forward to our upcoming conversations.”

Update #1 with some scenario analysis:

In case it’s useful here is how I would provide a framework for the stock going forward - please note this is absolutely NOT investment advice and this is very much “back of the envelope” analysis with so many assumptions it proves its own uselessness - it’s just one way of looking at the various angles on the stock. While I applaud Zillow’s aggressive effort to disrupt its own business, it comes with a widening range of outcomes and significantly increased risk. If the effort fails I think Zillow’s core advertising and media business could be worth about 60% of the current market cap, or 40% downside. That assumes most of the revenue holds, but they likely lose some of the base, and incrementally it’s not as high of a growth business in the future as some transactions shift to the iBuyer model (at competitors of Zillow like Open Door) or brokerages that don’t advertise on Zillow (such as Redfin). That would leave you with a business similar to 2018 which posted $1.3B in revenues and likely around $200-250M in FCF. I assume they need to continue the high level of advertising and marketing expense but could moderate other ancillary investments if growth slows down to a moderate pace. This assumes that Zillow can exit the iBuyer market if they don’t reach their goals without significant balance sheet harm - that’s a BIG “IF” still. This would leave a moderately growing, strong vertical search media business in the US real estate market which I would put a moderately high FCF multiple of 20x on. That gives around $4.5-5B in market cap compared to the $8.3B today (as I write this on 2-27-19 ZG is trading around $41). Zillow has net cash of $700M, but I believe there is balance sheet risk to the iBuyer model, and I am going to put that aside for this analysis. So, that gives around 40% downside with some fat tail risk of an existential balance sheet crisis if they cannot effectively offload capital risk and they concurrently see a negative impact to their pre-existing core business. I think this is a fairly conservative analysis of the downside scenario and it’s quite possible things end up much better than this even if they fail at the iBuyer market.

With that sort of downside profile, as a long term investor I would want to see the potential to compound at 15-20% or more over the next 5-10 years. Or effectively I would ask the question, what would need to happen to give Zillow a 2-3x market cap from here? A shorthand way to think about this would be to go out 5 years and use a multiple of 18x on FCF for a $18B market cap (roughly 2.5x over 5 years which is 15-20% compound annual returns) which implies they need $1B in FCF (4-5x the current level) or roughly $800M new FCF from the iBuyer business transition with minimal cannibalism to their core ads business today. At $5,000 in profit per home $800M in FCF would imply around 160,000 home transactions for Zillow or a 2-3 percent market share of the total. However if we look slice and dice the market into the addressable price ranges for the iBuyer model that would represent a somewhat higher percentage share. For some grounding of the numbers, discount technology brokerage Redfin was founded 15 years ago and in their 2018 10K indicated the have .8% share of the value of US home sales transactions. So, Zillow would need to achieve around 3-4x that success rate in 1/3 of the time. You can play with these assumptions plenty, so they are just illustrative - for example they might make more per home when you layer ancillary services like mortgages requiring lower market share, etc. There may also be a transformative merger that accelerates the transformation and assures a higher degree of success. Zillow has indicated publicly that they think this is a $20B revenue opportunity at 1% share and could be around $600M in EBITDA (let’s assume that’s FCF, which it’s clearly not, just for the sake of simplicity) in 3-5 years. My assumptions are different, but in the ballpark of what the company is framing for investors.

There are TONS of assumptions here, and I want to come back to one of my opening statements that I think this outcome here is likely to be more binary. It’s more likely that either 1) Zillow far exceeds the assumptions in the paragraph above and Zillow or someone else like Open Door creates escape velocity in the iBuyer market, OR there is a shock to their business and they end up with a small but decent media company in the best case outcome...or are forced to sell a distressed business in a worse case outcome. If Zillow can actually drive $1B in FCF off the iBuyer model with all of the TAM expanding opportunities, then that implies they can probably drive $10B in FCF off it.

This is a classic example where Bayesian logic will inform an investment decision. Put a flag in the ground today on your scenarios and objectively analyze each new incremental data point to move your credence up or down with as little cognitive bias as you can humanly muster - that means you need to find a partner in your analysis who will hold you accountable for remaining objective to the facts. This is also a classic example of a complex adaptive system where the outcome is unknowable with any certainty. Therefore, as you gain more confidence that you are making fewer predictions for your world view to come true, own more, and if instead you are making more specific predictions with a wide range of outcomes, own less or sit on the sidelines. We discuss this type of analysis and portfolio construction process in our investing white paper and there is an excellent and brief overview of Bayesian logic you can find here. Lastly I want to say this one more time: Zillow’s bold move to disrupt their own business and industry is what many companies are facing across many industries around the world today. While it’s the right strategy to undertake, most of the time it will fail. It takes a strong leadership team and culture of innovation and adaptability to have a shot, and that means Zillow has a shot, but only time will tell.

Update #2 from the 3-3-19 SITALWeek: A couple of additional points: 1) Why would Zillow be the winner of the “winner-takes-most” iBuying transformation of buying and selling houses? I see two possible answers, both speculative: first, brand and aggregation of users (Zillow is the top real estate portal by far), and, second, culture and execution (Zillow has a great culture of innovation, execution, and listening to customers). These are its advantages over challengers, like Open Door, in my opinion. It’s possible, however, that some other advantage, like access to capital or ability to sustain long-term loses, will be the winning determination – it’s up in the air. 2) I wanted to make another point regarding Redfin, which I think is taking an approach with a narrower range of outcomes and increased chance of success in the segments of the market they shine in: by providing an iBuyer offer to interested customers (but then having the option to instead sell that customer’s house with varying degrees of assistance for a range of fees) an integrated-technology brokerage model like Redfin seems to me to have the best consumer value proposition today. Redfin’s CFO described this in part at a conference this week:

“So where I think it fits in really is this set of 3 choices for the consumer. For some people, 1% pricing or 1% listing fee will make the most sense. Their home looks great. They can put it on the market today. They can pay the lowest possible fee. For other people, there's some work that needs to be done on the home, but the customer is willing to take some of the pricing risk associated with that, and that's how I think about Concierge Service. And then RedfinNow is the service that provides the most convenience for the customer, but we're taking the economic risk as the company, and so as a result, the customer likely receives fewer dollars than he or she would on that transaction. And so I really do think of these 3 services as being across the spectrum of the risk the customer is taking and the risk that the company is taking.”


Nothing in this newsletter should be construed as investment advice. I may own long or short positions in stocks discussed in this newsletter. This newsletter is simply an informal gathering of topics I’ve recently read and thought about. It generally covers topics related to the digitization of the global economy, technology and innovation, macro and geopolitics, as well as scientific progress especially in the fields of cosmology and the brain. I will frequently state things in the newsletter that contradict my own views in order to be provocative. I may change my opinions without updating them in the newsletter. Lastly, often I try to make jokes, and they aren’t very funny - sorry.

About me:

I was the portfolio manager of the Janus Henderson Global Technology products (ticker: JAGTX) from May 2011 to November 2018. Prior to that I held various roles as an analyst and portfolio manager at Janus Henderson Investors for most of the period starting as a summer intern in 1998 up until the end of 2018. I graduated from Williams College in 2000 with BAs in Economics and Astrophysics. A complete resume can be found at

Investment framework co-authored with Brinton Johns “Complexity Investing” can be found here:

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