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...
Last night, the online real estate company best known for its "Zestimates" of how much your house is worth reported earnings for its fiscal third quarter 2018. On the one hand, the news was good -- Zillow beat earnings expectations (barely). On the other hand, the news was bad -- Zillow missed revenue expectations (also just barely). But it's something else that really has investors worried today.
Here's what you need to know.
An earnings beat, but...
Zillow Group lost money in Q3, reporting a fraction of a $0.01-per-share loss. However, the company says its pro forma profits, which back out expenses that Zillow considers to be "one-time," were positive at $0.18 per share, and because it was this pro forma number that Wall Street was thinking of when it projected a $0.17-per-share profit for Zillow in Q3, Zillow is considered to have beat earnings.
On the other hand, Zillow's sales came in a bit lighter than the expected $343.7 million -- the company reported $343.1 million in sales instead. Thus, despite growing its sales 22% year over year, Zillow still managed to miss on sales.
But what really seems to have set investors off this morning is the new guidance that Zillow issued for its fourth fiscal quarter, which is already underway. On Yahoo! Finance, analyst projections for the current quarter are running just under $368 million for Zillow's sales, and $0.19 per share for its pro forma income. In last night's report, however, Zillow warned that sales will more likely run between $340 million and $357 million (missing Wall Street's mark by as much as 8%). Management didn't even give a hard number for its earnings expectation, instead issuing only an adjusted EBITDA projection of $26 million to $38 million.
While it's hard to know exactly what to make of such a doubly pro forma number as adjusted EBITDA, Zillow was clear on one point: The number is worse than what management had hoped for. As the company explained: "[W]e are adjusting our full year 2018 consolidated Adjusted EBITDA outlook to reflect lower than anticipated Premier Agent revenue and increased expenses, primarily headcount-related, as a result of higher-than-anticipated recruiting and relocation costs, and the impact of compensation inflation from the highly competitive job market."
Translation: Whatever the profits number ultimately turns out to be, it's going to be bad.
How Wall Street responded
As you can imagine, Wall Street didn't like this news one bit. So far four analyst reactions have been posted on StreetInsider.com (subscription required), with two bankers -- Deutsche Bank and RBC Capital -- cutting their price targets, and two more -- Susquehanna and Zelman & Associates -- downgrading the stock.
Zelman cut Zillow stock all the way to sell, warning that "investors are underappreciating the headwinds facing the company." (Possibly in reference to the fact that Zillow's new Zillow Offers home-flipping business bought 168 houses in the quarter, but only managed to resell 36 of them.)
Susquehanna was only a bit more forgiving, changing its rating to negative on worries that "growth and margins [are] likely in perpetual deterioration mode," limiting the stock's value going forward. In Susquehanna's estimation, Zillow now comprises two separate businesses: its core real estate information franchise, which "deserves a low-to-mid-teens EBITDA multiple," and its new house-flipping business, which "should be valued at 1-2x sales."
I admit that I'm having a bit of difficulty following Susquehanna's math here, as well as its decision to apply one valuation metric to half of Zillow's business, but use a completely different yardstick when measuring the other half. Still, after crunching its numbers, Susquehanna ultimately comes up with an answer to what it thinks Zillow stock is worth: $23 a share.
What it means to investors
If you've been keeping score at home, you know that Zillow stock has fallen a further 4% since I began writing this article, and is now down nearly 24% on the day -- yet still costs more than $31 a share. And this may be the most terrifying fact of all: If Susquehanna is right, then despite falling 24% already, Zillow may be nowhere near the bottom, but rather, still needs to fall another 26% or so before it hits fair value!
Is the situation really as bad as that?
Actually, I fear it may even worse than that. Consider: Pro forma profits, adjusted EBITDA, and other financial make-believe numbers notwithstanding, the truth is that Zillow hasn't earned an actual GAAP profit since 2012 -- and even in that year, it earned only $6 million, which is a pretty paltry sum for a stock valued in excess of $6 billion.
Even being generous and valuing Zillow on its much more substantial free cash flow ($124 million over the last five months), and adjusting that for the stock's 5% projected earnings growth rate as estimated by S&P Global Market Intelligence, the best fair value I can come up with for Zillow's market cap is just $620 million or so -- which is 90% less than what it is today.
Much as I hate to say it, and as aware as I am that many Fools will disagree with me, I have to side with the analysts on this one: Zillow stock is overvalued -- and it's still got a long way to fall.