Ever since inflation hit a 40-year high in June 2022, the U.S. Federal Reserve has been on a campaign to hike interest rates at the most aggressive pace in its history to help get inflation back toward a more normal level. Naturally, this had an impact on consumer spending, business investment, and, of course, the real estate market.
A recent report by Redfin suggests the average homebuyer with a $3,000 monthly budget has lost a whopping $40,000 worth of purchasing power over the last year. Those rising interest rates also pressured U.S. existing home sales data, which came in at a six-month low of 4.04 million (on an annualized basis) in August. The 25-year mean is closer to 5.3 million. That has caused a slowdown at Zillow Group (Z 1.68%) (ZG 1.70%), a real estate technology company providing seller services, mortgages, and software products to agents.
But some economists believe the Fed has finished raising interest rates, and it might even begin cutting them in the middle of next year. If that's the case, could now be the time to load up on Zillow stock? Let's find out.
Image source: Getty Images.
Zillow is in the midst of a major transition
Two years ago, Zillow's largest business was iBuying (or direct buying), which involved purchasing homes from sellers with the intention of flipping them for a profit. However the company pursued an aggressive strategy in that segment, and as worries about rising inflation began to stall the economy in mid- to late-2021, Zillow's losses started to mount. It was forced to exit the iBuying space completely and spent most of 2022 selling off its remaining inventory at a loss.
Zillow is now leaning into its portfolio of real estate services, and it continues to develop its mobile application for residential properties, which has a dominant U.S. market share. The company is leveraging that leadership position to build what it calls a "housing super app," which will deliver almost every service a buyer and seller will need to complete a transaction.
Zillow estimates the average home sale generates around $17,000 in fees from listing services, touring, financing, closing services, and more. But the company was only capturing around $4,100 of that last year, and it wants to grow that figure to $5,200 by 2025 as part of its next chapter without iBuying.
True to its technological roots, Zillow is investing heavily in artificial intelligence (AI) to transform the listing experience to help agents close more deals more quickly. The company has begun rolling out its Listing Showcase feature, which uses AI to select images based on a potential buyer's preferences and to create interactive floor plans to give online viewers a better idea of the home's look and feel. The goal is to give prospective buyers an immersive virtual experience to increase their likelihood of pulling the trigger.
Listing Showcase will only improve over time as the AI models train on more data, and it has the potential to increase Zillow's market share of homes sold -- a key factor in the company's future growth plans.
Zillow's financial growth has stalled (for now)
Zillow's revenue is on track to plunge 69% this year to $1.9 billion, compared to its 2022 result of $6.1 billion. That's the magnitude of the hole left by iBuying, because each home Zillow sold under the program counted as revenue.
Unfortunately, Zillow's services revenue also shrank by 6% year over year in the first six months of 2023 due to the challenging environment for the housing market. Mortgage revenue led the decline with a drop of 33% year over year, whereas Zillow's rentals business was the only segment showing growth. That strength came from more multifamily homes listed on Zillow's rentals platform, and new supply hitting the market drove more advertising spending from landlords.
Since services are capital-light businesses compared to iBuying, Zillow is on the way to GAAP profitability. The company posted a net loss of $57 million in the first half of 2023, but after stripping out one-time and non-cash expenses, it delivered positive adjusted EBITDA of $215 million. Zillow spent $147 million on stock-based compensation, for example, which is a non-cash expense and technically doesn't impact the company's financial position despite detracting from its GAAP earnings.
Wall Street analysts expect Zillow's revenue to come in at $2.1 billion in 2024, which would represent growth of 12% (if the 2023 estimates are correct). It might be enough to tip the company into positive territory on the bottom line, assuming it doesn't increase its operating expenses at a faster rate.
Why Zillow stock is a buy now
Any upside to analysts' revenue forecasts for next year could depend on what happens with interest rates. According to the CME Group's FedWatch tool, investors predict the Federal Reserve will cut rates in June, September, and December 2024. That would almost certainly bring some homebuyers off the sidelines.
But setting aside the short-term interest rate picture, Zillow has charted a path to $5 billion in annual revenue by 2025. That would be a whopping 163% increase in just the next two years, based on where the Street expects 2023 revenue to come in. Zillow also estimates it will generate $2.25 billion in adjusted EBITDA in 2025, so it could be an incredibly profitable enterprise.
Those projections might be a little ambitious given they were outlined at the beginning of 2022, before the market deteriorated. But even if it takes an extra year, investors are still getting a good deal on Zillow stock today. Why? Because if its price-to-sales (P/S) ratio of 5.1 remains constant, it implies Zillow stock will more than double by the time the company achieves $5 billion in annual revenue.
However, that P/S ratio is 44% below where it was in 2021 right before Zillow exited the iBuying business. I'm not saying it will climb back to those levels, but there will likely be a case for multiple expansions once the company returns to generating consistent growth and profitability (i.e., investors might be willing to pay a higher P/S ratio for the stock).
In any case, Zillow's future looks bright and the upswing could occur as soon as next year, so now might be a great time for investors to buy the stock.
