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Bear Of The Day: Zillow Group (ZG)

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Zillow Group (ZG - Free Report) has been under significant pressure since it peaked in mid-February, with its latest earnings report at the beginning of November spelling tragedy almost every way you look at it. ZG has lost nearly 70% of its value in the past 9 months, and analysts are still bearish on this ostensibly mismanaged homebuying application as earnings estimates for the next couple of years drop precipitously, pushing Zillow into a Zacks Rank #5 (Strong Buy).

Overleveraged Operations Reveal A Careless Management Team

Zillow missed big on both its top and bottom-lines in its Q3 earnings report released November 2nd exhibiting its most significant quarterly loss to date. As the booming housing market cooled off this past quarter, the company accumulated a massive $422 million loss in its Zillow Offers segment (digital house flipping) as it buys too much too fast. Offers' one-quarter loss almost double its total 2020 losses.

This led to management's abrupt move to completely exit the iBuying game (aka Zillow Offers). Zillow's co-founder & CEO Rich Barton cited the volatility and unpredictability of forecasting home prices as the primary reasoning for winding down Zillow Offers.

This significant operational shift came out of left-field, with the prior quarter's report highlighting the success of the Zillow Offers division. This digital real estate giant's AI-powered software for buying and selling homes was overpaying for thousands of homes, leading to this sudden business transformation. Zillow announced that it would be cutting its staff by 25% (roughly 2,000 employees) to pare future losses and will be off-loading the nearly 10 thousand homes currently in its inventory in the coming quarters (likely for a loss).

It's ironic actually because when Zillow Offers was initially announced that its plans to enter the iBuying business in 2018, most of its investors ran for the, cutting the price of ZG in half that year. The digital house flipping game is risky because of the extreme amount of leverage required to execute the level of real estate ownership Zillow had eventually come to.

However, Zillow Offers began showing a robust trend towards profitability amid the pandemic and revealed positive returns in its prior 3 quarterly reports (Q4 2020 to Q2 2021). Investors had begun getting optimistic about the opportunity in this house-flipping market as residential real estate prices across the country continued to skyrocket, and ZG's proprietary model had seemingly proven itself.

Ultimately, Zillow overleveraged its house-flipping operations, which I attribute to the management team's blind greed, leading to the stock's eventual capitulation. Its Q3 balance sheet revealed that its credit facility borrowing had ballooned 300% in just one year to $2.67 billion, not to mention its total liabilities have nearly doubled. At the same time, its volatile housing inventory exploded with a constant stream of apparently overvalued purchases driving this asset line item's total value to $3.76 billion, 7.7 times its inventory from a year prior.

There is no doubt that Zillow overextended itself in the iBuying space, and now it's paying the price.

Zillow was far from the only iBuying real estate player out there, with start-ups like Opendoor Technologies (OPEN - Free Report) and Redfin (RDFN - Free Report) engaging in similar business lines. RDFN's share performance is almost an exact mirror image of ZG, while OPEN appears to be the outperformer. We will see if Opendoor can maintain its relative outperformance following its earnings after the bell this evening.

What Now?

Investors were slowly walking out the door following the frothy, nearly $50 billion valuations that ZG got to in February. However, now that the stock's most significant topline driver (finally demonstrating positive returns in recent quarters) is being completely pulled off the table, shareholders are sprinting for the exit, while analysts downgrade ZG like there is no tomorrow for this company.

ZG is already down 36% month-to-date in just a week and a half of November trading we've seen thus far.

The Pollyanna of market-disrupting innovators, Cathie Wood, has even been dumping ARK Invest's (ARKK - Free Report) ZG stake as management illustrates a lack of competence this past quarter. ARKK has sold out of 83% of its Zillow position following the dreadful Q3 report at the beginning of the month. With dip-buying money managers like this jumping ship, I wouldn't be touching this stock.

Analysts have dropped price targets across the board, with some taking their once lofty projected targets down below its already capitulated price tag. I'm not recommending you short this unpredictable stock, but I would avoid it until its management team can get their ducks in a row.

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