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Zillow Group Stock Downgraded After Earnings: What You Need to Know

By Rich Smith - Aug 7, 2018 at 12:06PM

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First Zillow missed earnings. Then it lowered guidance. Selling ensued.

Every day, Wall Street analysts upgrade some stocks, downgrade others, and "initiate coverage" on a few more. But do these analysts even know what they're talking about? Today, we're taking one high-profile Wall Street pick and putting it under the microscope...

Shares of Zillow Group (ZG -4.92%) (Z -5.29%) were looking good heading into earnings. Investors were optimistic that news from the online real estate information provider would be good, and the shares climbed more than 1% in the hours preceding release of the company's Q2 report -- but then the bomb dropped.

In what analysts are describing as a "miss and lower" report, Zillow first failed to earn as much as Wall Street thought it would last quarter, then warned that its earnings for the rest of this year might not measure up, either. Zillow shares are down significantly in morning trading -- on the order of 16% -- and analysts are rushing to cut their price targets, and in some cases even downgrading the stock.

Here's what you need to know.

Red arrow on chart going down

Zillow stock is crashing. These analysts aren't helping matters any. Image source: Getty Images.

The news

Let's begin with the earnings news. Zillow released fiscal Q2 2018 earnings results after close of trading yesterday. Sales for the company climbed 22% year over year to $325.2 million, with Zillow's Premier Agent, Rentals, and New Construction marketplaces leading the way. Zillow failed to earn a profit, however, losing $3.1 million for the quarter.

On the plus side, this was less than the $21.8 million lost in last year's Q2. More importantly, the company generated much more free cash flow in Q2 2018 than it did in 2017 -- $33 million. That brings Zillow's total cash haul for the past 12 months to $180 million.

That's actually pretty good news. Investors, however, are accentuating the negative today, displeased that Zillow missed Wall Street's prediction that it would return to profitability in Q2. Worse, they're punishing the stock for issuing much lower guidance numbers for fiscal Q2 and full-year 2018 than analysts had told them to expect.

According to published estimates on Yahoo! Finance, Zillow is supposed to book more than $412 million in revenue this current third fiscal quarter -- and nearly $1.5 billion for the full year. Yesterday, however, Zillow told investors it would more likely book at most $347 million in Q3 (a 16% shortfall) and $1.35 billion for the year (more than 9% below estimates).

What Wall Street said about that

Wall Street was not amused. Commenting on the results, analysts at Jefferies called Zillow's guidance a "shocker," and highlighted apparent weakness in the company's "Rentals" and "Other" divisions, as well as its new "Homes" business, which buys houses directly from homeowners with the aim of later selling them for its own profit.

KeyBanc worries that there's a lot of "noise" surrounding Zillow's business now, both from the new Homes business and also Zillow's decision to buy Mortgage Lenders of America, L.L.C., a national mortgage lender headquartered in Overland Park, Kansas. Although KeyBanc likes how company is broadening and expanding its business into new facets of the real estate market, it worries that the reduction in guidance plus the still-unknown effects of getting into mortgage lending could keep buyers away from Zillow stock.

Although still optimistic about the stock for the long term, KeyBanc cut its price target on Zillow to $56 a share, as reported today by TheFly.com. Jefferies thinks it's worth even less -- $52 a share.

The downgrade

The worst news of all from Wall Street, however, is that Merrill Lynch has decided to downgrade Zillow Group stock. So far, while several peers have cut their price targets, most banks that were fans of Zillow before earnings are still officially holding firm on their buy ratings today (albeit with lowered targets).

Merrill, however, not only cut its price target to $60 a share, but also downgraded Zillow to neutral, saying that "Zillow is taking longer than expected to ramp up the Homes business" and warning that Zillow's "new construction opportunity is also taking longer to materialize." Like the other analysts, Merrill seems to think that these are the flaws in Zillow's business that drove the disappointing guidance.

What it means to investors

If there's any consensus on Wall Street, therefore, it appears to be this: Zillow remains a good company and one that can still grow in the long term. At least in the near term, though, growth is not going to be as strong as Wall Street had hoped it would be, and Zillow will have to take more time to ramp up the areas in which it hopes to grow in the future. 

The bigger question I think investors face here, though, is whether Zillow stock is worth buying even if it does succeed in growing like Wall Street expects it to. After all, according to data from S&P Global Market Intelligence, the average Wall Street banker's estimate for Zillow's long-term earnings growth rate is just 5% annualized over the next five years.

Meanwhile, Zillow stock is still unprofitable -- and even when valued on free cash flow rather than GAAP earnings, it trades for nearly 65 times FCF. I have serious doubts that a 5% long-term growth rate will be sufficient to sustain that multiple going forward. Unless those estimates are even more wildly off target than the estimates that Zillow failed to meet in Q2 were, this stock looks overpriced to me -- and deserves even more downgrades than the one it received this morning.

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Stocks Mentioned

Zillow Group, Inc. Stock Quote
Zillow Group, Inc.
ZG
$40.23 (-4.92%) $-2.08
Zillow Group, Inc. Stock Quote
Zillow Group, Inc.
Z
$40.96 (-5.29%) $-2.29

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