Zillow (NASDAQ:Z) (NASDAQ:ZG) has become a bit of a battleground stock since it announced its new big play -- Zillow Offers, a platform that lets customers sell their homes directly to Zillow online. On one hand, the real estate market is ripe for disruption, and Zillow Offers is definitely alluring for consumers. On the other hand, Zillow is losing money on every sale. Is there a path to profitability and long-term market dominance? In this week's Industry Focus: Energy, host Nick Sciple and Motley Fool contributor Luis Sanchez look over the potential outcomes. How could Zillow make this a profitable venture? What happens to real estate agents? How does Zillow Offers stack up against the competition? Can it scale? What should investors watch to track Zillow Offers' progress? Tune in to learn more. 

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This video was recorded on Sept. 5, 2019.

Nick Sciple: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. Today is Thursday, Sept. 5, and we're breaking down Zillow's plan to shake up the homebuying process. I'm your host, Nick Sciple. Today I'm joined by Motley Fool contributor Luis Sanchez via Skype. How's it going, Luis?

Luis Sanchez: Good!

Sciple: How's your summer been? We just passed Labor Day, so it's the unofficial end of summer. What have you been up to this summer?

Sanchez: Summer went well. I guess it is over now. But to be honest with you, Nick, the last few weeks have been pretty stressful for me. I live in New York City. My wife and I are getting ready to move into a new apartment at the end of this month. As you can probably imagine, moving in the city is a real hassle. Apartments are super competitive to lock down. Moving our stuff across the city is also not very fun. For the last month or so, we've been checking this apartment finder app called StreetEasy pretty regularly now. That ties in to what we're going to discuss today because StreetEasy is actually owned by Zillow. It's actually been pretty essential for us in finding our new apartment in the city. It's a great example of how technology is changing the process of finding a place to live. 

Sciple: Yeah, for sure. You talk about StreetEasy, when I moved to D.C. a little over a year ago, I used an app called HotPads, which I believe is also affiliated with Zillow. It's another one of these things. They say software is eating the world, real estate may be the next iteration of that. 

We're going to talk about Zillow today. Most of our listeners are probably familiar with Zillow; they know about the Zestimate. You can look and see how much your neighbor's house is worth, those sorts of things. It's really helped empower buyers during their home shopping process. They can know how much these houses are estimated to be worth. Luis, can you give us a high-level view of what Zillow's business actually does and how it makes its money?

Sanchez: Sure. By way of background, the company was actually founded back in 2006 by Rich Barton, who also founded Expedia and Glassdoor, and another guy, Spencer Rascoff, who is the guy that founded Hotwire. Barton and Rascoff are still involved with Zillow and actually still own a lot of the company. When they started Zillow, it was basically a website where people could list their homes for sale or for rent. Their big idea was simply to make money on advertising, either through display advertising or by partnering with real estate agents and landlords. What's developed is basically their bread and butter business, which they call Premium Agent. That business is basically Zillow selling leads to real estate agents and landlords. The way it works today is, if you're looking to buy a home or move into an apartment, you go to zillow.com and research prices, research your neighborhoods. You might see something you like. Your next impulse, obviously, is, "How do I contact the buyer?" Very handily off to the side, there might be an advertisement for an agent that covers that zip code that could actually help you broker that transaction. 

Sciple: Right, and that agent has paid money to Zillow to be there, which has been the foundation of that core business. It's matching these buyers that are looking for properties with these agents that have paid Zillow to be up there. When you take a look at how that business has performed over time, are they dropping profits to the bottom line? How well has that business performed since Zillow has gone public?

Sanchez: Growth-wise, it's done really well. Since they IPO'd in 2011, revenue has something like 30Xed. That Premium Agent business, that advertising business, is still technically unprofitable, but it is cash flow positive to the company. Big picture, if we're looking at the company today, it's basically the website for conducting research on buying a home. It's clearly built a very valuable platform. Something like 200 million unique visitors per year on its website, over 100 million homes in its database. A couple of years ago, it acquired Trulia, so now it owns the two most popular home real estate websites. 

Now, the company has been trying to figure out what's next. They've already built this great advertising business. The growth in that business has slowed lately, but they've accrued a lot of value to their platform, and a lot of traffic. This is where the story gets interesting. Now, Zillow is essentially taking another step -- back in 2017, it started testing out this marketplace platform where third parties could get on Zillow's website and use its platform to actually directly buy and sell homes. Earlier in 2018, Zillow actually took it another step further and launched this product called Zillow Offers, where now Zillow will actually directly itself buy homes and then sell them on its platform. It started small. Zillow Offers was just in a handful of markets last year. But it's been pretty quickly ramping up. The company expects to be in about 26 markets by mid-2020. 

Sciple: Luis, this i-buying trend, some folks might criticize it and say, this is a fancy form of home flipping. But Zillow, many people argue it's a little bit different. How is Zillow's approach to this i-buying or home flipping transaction different from the way things have been done in the past?

Sanchez: Technically, Zillow is flipping homes. But I think Zillow the company characterize it a bit differently. Their goal is to provide liquidity to the housing market. It's a liquidity service. Clearly, buying a home is a huge transaction. It's one of the biggest, if not the biggest transaction an individual will make. That's a very complicated process. It usually takes a while to flow through. Zillow's thinking is, let's add technology to this, and through the process, make it run more smoothly. 

The way it actually works in practice is, if you're looking to sell your home, you go on Zillow's website, you might already be going on Zillow's website just to see what your home could be worth. Now, off to the side, they have this little ad that says, "Click here to see if you qualify for an instant cash offer." And you basically fill out a quick survey. It might take five or 10 minutes. It's just a questionnaire about some basics of your home. Zillow will turn around and email you maybe a day or two later with a range of what they might be willing to pay you -- so, actually a cash offer. If you want to proceed, they'll actually send an inspector to your home within a couple of days to make sure that everything is as described. If you choose to accept that offer, you can actually get a 100% cash offer from Zillow within 90 days. In exchange, Zillow will charge a transaction fee between 6% to 9%. That fee will vary depending on a few factors. At the end of the day, Zillow needs to sell the home on the other side, so they're probably going to do some renovations. There might be an estimate of how long they think it'll take to sell your home. Paying 6% to 9% sell your home is definitely a little bit pricier than going through a traditional real estate agent process. A real estate agent might charge you 3%. But the service that you're getting as someone who's selling your home is a quick close and that certainty of that all-cash offer.

Sciple: Right, it's that idea that, when you own a house and you're moving to another house, you have a lot of cash tied up in that property. If you could get cash quick from Zillow or another one of these i-buyers, it makes the ability to move into your new property a lot easier and less stressful. Then, as well, as you mentioned, with Zillow being such a popular platform for finding homes, you can see where they can bubble up the homes on their balance sheet up to the top of the list and start promoting those. 

OK, Luis, as we talk about this i-buying, home flipping model, adding liquidity to the real estate market, you can see how it makes a lot of sense for buyers. Do you think Zillow is actually going to make money on this? As we mentioned off the top, this is a company that wasn't showing accounting profits in its core advertising business. Now you're moving into a significantly more capital-intensive business than that legacy offering. What are the financials looking like so far?

Sanchez: Making money is a funny term these days for growth stocks. Clearly, the trend isn't for companies to be that focused on making money. Zillow seems to be embodying that spirit of the latest trend of these tech companies. Technically, Zillow isn't showing a profit on an accounting basis for its advertising business, although it is cash flow positive, and that's definitely worth noting. It's self-financing. They're definitely using that cash flow from the advertising business to help get this home buying business off the ground. 

The idea here is that as Zillow is ramping up this business, they're going to burn a lot of cash because they're going to have to buy a bunch of houses before they sell them. So far, it's proven to be just that. In the first half of 2019, Zillow lost over $116 million in terms of operating losses. Perhaps these operating losses are a bit overstated because the company isn't operating at scale yet, and there's plenty of start-up costs and overhead costs that come with starting a new business and rolling out to all these new cities. 

I think it's most helpful to focus in on the economics of the average home flipping transaction. Zillow actually does a really good job of providing disclosures for that. According to Zillow, in the second quarter of 2019, which is the most recent quarter, they sold 786 homes. On average, they purchased a home for about $286,000. On average, it sold a home for about $317,000. Right off the top, that's a $31,000 gain per home, which is about 11% gain. Although, it's worth noting that 11% gain includes their 6% to 9% commission. 

But there's additional costs in there. Zillow basically discloses that on average, for each home, it incurs about $29,000 in additional expenses to renovate each home and also to sell each home, and then another approximately $4,000 to $5,000 in interest expense that it incurred to borrow money to buy each home. So, if you add the interest expense to the selling costs, Zillow is actually burning a couple of thousand dollars for each home at the transaction level. That is actually not accounting for any of the overhead costs, including a pretty heavy cost for tech development and advertising. 

So, basically, this Zillow Offers business is a negative gross margin business as it is today. And then, of course, it's an even more negative operating margin business right now.

Sciple: You have a $31,000 profit off the top, and then immediately $29,000 goes out the door for refurbishing costs. You can see how it's difficult. And, you take into account interest expense and marketing to make sure people know about this program, and those sorts of things. It's difficult to maintain profitability. But it's worth noting, this is very early days for the business. 

Luis, when it comes to the end game for this company, when Zillow reaches scale, what is Zillow's plan to use this home buying business? How does that fit into the overall strategy Zillow has going forward?

Sanchez: Clearly, Zillow has a plan here, albeit it's a pretty ambitious and visionary one. The way I have thought about it is, there's a few different legs to the stool of profitability for Zillow Offers, so to speak. The first one is, Zillow believes that once they get this Zillow Offers business to scale, they can actually make a slight profit on the actual home flipping part of the equation. But really, it looks like the real money is actually going to be in building businesses outside of directly buying and selling the home. Zillow wants to create this whole ecosystem of using its platform as a place to transact on homes and then cross-selling other services to people. Obviously, the company already has advertising relationships with real estate agents. If you're someone who's selling a home on Zillow, you may also then use Zillow if you're going to go buy another home, and therefore, you may be inclined to use the premium agent product through Zillow. 

More interestingly, though, perhaps, is that Zillow is actually getting into other businesses related to the transaction process. Last year, Zillow acquired a mortgage company. They hope to attach mortgages to different transactions on their platform. There's a whole host of other ancillary services that you could see them attaching that they've also laid out in their filing. These services include everything from title insurance to escrow, moving services. If you start to think about it, these other businesses, including the mortgage business, are a lot more straightforward fee-for-service businesses that have a really straightforward cost structure. It's really easy to see Zillow making a profit if it can bundle up a lot of these services, in addition to flipping the home. 

I think this whole exercise is more of an ecosystem play. To the extent that Zillow can get scale in this product and build other services around buying and selling homes, it could actually work. 

Sciple: Yeah. This story sounds very similar -- I'm a shareholder of Redfin. Redfin has done a lot of similar moves when it comes to adding on mortgage services, and title services, and all those sorts of things adjacent to their business to layer on to their core brokerage product. It sounds like what Zillow is attempting to do is a very similar model. Driving the cost down with this home i-buying model and then using that to feed into these other businesses that are clear higher gross margin businesses. When you look at what Zillow is doing here with i-buying, how does that compare to maybe what Redfin is doing in its business, and maybe what other i-buyers are trying to do?

Sanchez: Zillow is certainly not alone in getting into this instant cash offer business and flipping homes. There's a whole industry emerging now. They're referred to as i-buyers. Redfin's a great example. Redfin has this product called Redfin Now. It's a lot more limited in scope. They're in fewer markets, but they're essentially doing a similar thing in terms of providing instant cash offers and then turning around and trying to sell homes for a slight profit. Redfin is actually already in some of these ancillary businesses like mortgages and title. They seem to have a similar game plan. Although, Redfin's definitely a little bit of a different animal because they also have an online brokerage platform where they charge a reduced brokerage commission to do that agency process through their online platform. They have some interesting things going on, too. Interestingly, you could pay an additional 1% on top of your brokerage commission to Redfin, and they will offer something called concierge listing, where Redfin will actually come and stage your home, host an open house, and basically run the whole process of selling the home for you. Or, if you're a Redfin customer and you want to go ahead and sell your home to Redfin, similar to Zillow, they'll offer you, if you qualify, a cash offer, and they'll charge you a 7% transaction fee for that.

In addition to Redfin, there's quite a few other i-buyers out there. Some of them have their own idiosyncrasies, or their own different spins on the process. There's this one service I saw called Knock which allows homeowners to trade in their homes, kind of how you might trade in your car if you're buying a new car at a dealership. There's this other company called Offerpad, which is backed by Blackstone, and they've raised quite a bit of money, something like $400 million or $500 million. And then there's this other company called Open Door, which has gotten a lot more publicity. They're venture backed. They're reported to be spending something like $4 billion a year at this point purchasing homes. They're pretty big player. I believe they've actually partnered with Redfin in a few markets.

So, the next logical question is, with all these i-buyers, what is the competitive dynamic going to look like? There's a few cities where there's already a few different i-buyers competing with each other. You have to think that some i-buyers are probably going to be a little bit more aggressive in bidding for homes, and that could put downward pressure on their ability to flip the homes for a profit. But there's still a lot of markets where there's only one or two or even no i-buyers. I think this comes back to why Zillow is so aggressively expanding its i-buying business. It wants to get there first. It wants to get there before other i-buyers can dominate the market. 

Sciple: I've heard anecdotally from some folks around The Fool that Zillow, when it comes to the i-buyer market, tends to be the highest touch, the most aggressive when it comes to offering and understanding the idiosyncrasies of a home. Then you have Redfin in the middle, and then Open Door with the least touch. Again, that's anecdotal from folks around the company. 

Another area, when you think about these major i-buyers moving into the real estate buying and selling space, is the agents. As we've mentioned, Zillow's legacy ad business is very much dependent on agents. As you see this i-buying scale up, if Zillow and these other companies are buying these homes, these are transactions that real estate agents aren't participating in. Is there any risk in your mind of, as Zillow moves into this i-buying businesses, there could be some negative impacts on its core ad business?

Sanchez: It's certainly possible. That business is basically built on real estate agents, which are the more traditional players, buying leads from Zillow to help in the process. One of the clear developments that is occurring through the development of the i-buying industry is that agents are getting left out of the process. They're being disrupted in a way that's not too dissimilar from how we've seen other industries get disrupted by technology. I can't imagine that agents are too happy about the developments in the industry as a result of i-buying. There's a lot of uncertainty with how the i-buying trends are going to shape up. Long-term, we really don't know if i-buying itself is going to work, if it's going to be profitable, if more than one i-buyer will be able to operate in this market. But, one prediction I won't be too shy about making is that I don't see how real estate agents are going to benefit from i-buying. I think they're getting cut out of the process. I wouldn't be too happy if I were a real estate agent here. 

Sciple: Yeah. You've got certain numbers of transactions they're being cut out of. As you mentioned, Redfin and others are putting downward pressure on the brokerage fees that they can demand. A tough time to be in that industry. But again, this is an industry that hasn't changed in a meaningful way in probably decades, so it's probably ripe for changes. 

As we talked about earlier, it's very early days for this i-buying businesses, Zillow Offers business for Zillow. The numbers haven't quite been as appealing as we would have liked to see so far. But, the business hasn't reached scale yet. How have investors reacted to this so far? It has been a battleground stock on some of these issues. 

Sanchez: Yeah, for sure. Zillow is certainly turning into a battleground stock. There's a lot of smart people on both sides of the bull/ bear debate here. Obviously, Zillow's insiders are super bullish. Rich Barton actually came back to be the CEO of Zillow earlier in 2019 after he went away to work on other projects, including founding different companies and working with a lot of VC-backed companies. It's worth noting that he was a significant backer of WeWork. Other than Rich Barton, there's actually been a lot of insider buying activity at Zillow. The insiders now own more than 15% of the company. So, they clearly believe in the prospect of i-buying long-term.

At the same time, nearly 20% of Zillow shares are held short. Quite notably, Steve Eisman, who is famously portrayed in The Big Short, is also short Zillow. He's done a few interviews where he's described his thesis. He makes a really interesting argument. He basically says that i-buying is a flawed business and points to the negative unit economics of it. He thinks that home flipping reminds them of a lot of the risk taking behavior that he saw in the housing bubble that caused the 2008 financial crisis. In his mind, real estate is an inherently local market, and it's not one that he sees as being conducive to a scale tech platform that other industries might be conducive toward. 

Zillow's stock price is actually down since the Zillow Offers business took off. But the trading has been pretty volatile. It seems like investors are still trying to figure out whether or not they believe in this new business or not. 

Sciple: Luis, one core question I have here, and maybe this is part of part of Eisman's case, is what economies of scale do you think come with this i-buying business? We've talked about, Zillow hasn't reached scale yet, that may be some reason behind why the profitability doesn't drop down. But at the end of the day, at the core, these are buying and selling homes. How scalable do you think this business model is for a company like Zillow? 

Sanchez: Yeah, I think that's an important question. There's certainly some aspects of this Zillow Offers business that do scale. The tech platform and the software development that underpins it is certainly something that can be done from a centralized location. There's certainly some brand advertising that could happen at a national level. But, yeah, at the end of the day, zooming in on the transaction, the housing market is inherently a local market. 

That being said, I think this business can still work for a company like Zillow, even if it is somewhat regional or local. That's simply because even regional housing markets are pretty huge. If you look at the total U.S. housing market, it's something like $30 trillion plus. You can look at where population centers are based. You can look at a market like, let's say, Los Angeles. That metro area has somewhere in the neighborhood of 5% of the U.S. population. 5% of $30 trillion is several trillion dollars. So, if you start thinking about these multi-trillion-dollar markets even at the local level, you can still make the economics work as long as Zillow finds a way to run its regions efficiently.

Sciple: Going from there, Luis, would you be an investor today? If not, what would you need to see to overcome that confidence interval to get you there?

Sanchez: I'm pretty torn. I don't plan on making a long or short decision anytime soon. On the one hand, I wouldn't want to bet against Rich Barton. The guy's founded three amazing companies. He clearly has his finger on the pulse here in terms of the market that he's in. If Zillow is correct about its bet on Zillow Offers, Zillow could be one of the next mega platforms in the tech industry, in the lines of an Amazon or a Facebook. The housing market is huge. It's many trillions in total addressable market. If Zillow can carve out even a modest niche, it'll definitely accrue a lot of value for shareholders. 

At the same time, I look at the economics of Zillow Offers today, and the numbers simply don't add up yet. I also see smart guys like Steve Eisman being really skeptical. And I think Steve Eisman makes some good points. I'm pretty comfortable watching from the sidelines for now. I would want to have more assurance that Zillow can achieve better unit economics and that there is a path for scalability here. 

I do believe that Zillow has some competitive advantages when it comes to the i-buying industry in general. Clearly, it has a great platform that could lower its cost of customer acquisition vs. some of its competitors. But I'm just not sure yet because it's doing something that's really bold, it's taking a lot of risk, there's also ways that this could really backfire for the company. In other words, I'm happy waiting and potentially buying Zillow's stock at a higher share price, but with more confidence in the business. 

Sciple: Yeah, Luis, I would count myself in that same boat as well. I own Redfin. I really do think that the real estate market is ripe for disruption. It's something that hasn't changed in a significant way over time. However, these are some very aggressive bets being made by a large number of competitors in this space. I'd like to see how things play out. When you were last on the podcast, we talked about the Virgin Galactic business and how I wanted to see them launch a few rockets safely before I wanted to buy in. I feel a similar way about the Zillow Offers business. I want them to scale this safely and see that we can make this work before I want to rush and buy in. 

However, if someone wanted to take a basket approach and grab Zillow, Redfin, the few folks that are playing in this space, I do expect there's going to be a big tech winner somewhere in the real estate industry. We'll just have to see which one it ends up being, or if there's going to be a large number of winners. As you said this is a very, very large market. 

Luis, one last question I do want to ask you, though. Whether or not you want to invest in the stock, would you ever use this i-buyer service as an individual? Why or why not?

Sanchez: I think the i-buying service for consumers is great. You can just fill out the survey, see what the i-buyer would be willing to pay for your home, and who knows? The offer could be really good. You could even pit up multiple i-buyers against each other and see which one gives you the best offer. They're all going to be a little bit different. At the very least, it gives you an out in case you can't find a traditional buyer for your home. Clearly, this is another example of where the consumer wins.

Sciple: Yeah. At the end of the day, the consumer is going to be a winner whatever ends up happening in real estate. For our listeners, if any of you have used an i-buyer, please let us know how your experience has been and what the process was like. You can shoot us an email at industryfocus@fool.com, or tweet us @MFIndustryFocus. You can also check us out on YouTube if you want to see some more of our content. You can see Luis and my smiling faces on the YouTube video feed of this podcast. Luis, thanks as always for joining me on the podcast! As I said, this is a super rapidly developing industry. I'm sure we'll have you back on again soon to discuss it as it develops. 

Sanchez: Yeah, thanks for having me! This was fun!

Sciple: Yeah, for sure! As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against the stocks discussed, so don't buy or sell anything based solely on what you hear. Thanks to Austin Morgan for his work behind the glass! For Luis Sanchez, I'm Nick Sciple. Thanks for listening and Fool on!

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.