The housing market is massively impacted by rising interest rates, which increases the cost of borrowing for mortgages. In fact, this looks to have resulted in over a 22% decline in the number of homes sold in the first quarter of the year according to data from the National Association of Realtors.
The good news is interest rates are high because the Federal Reserve has raised them to combat inflation. However, given the latest consumer price index numbers for April indicate a 4.9% rate, down from 5% in March 2023, it looks as though the central bank's strategy is working.
Inflation still has further to fall to reach the 2% target rate, but in the long term, I would expect interest rates to be reduced again and the housing market to rebound. As such, I will take a look at two companies that would be primary beneficiaries of this trend in the long term.
Zillow
Zillow Group Inc. (Z, Financial)(ZG, Financial) is the leading online property portal in the U.S., with over 220 million unique visitors per month to its website.
The company has experienced major challenges after a botched iBuying operation, which led to the shuttering of that business.
I personally believe this will be positive for the business in the long term as it can refocus on its capital-light, higher-margin online business.
This is also the business model where Zillow's founder and CEO has the most expertise. Rich Barton was also the co-founder of Expedia (EXPE, Financial) and Glassdoor, two very successful online businesses.
Moving forward, Barton has laid out bold plans to increase the percentage of property transactions captured by Zillow from 3% to 6% by 2025.
To accomplish this goal, the company has outlined a five-pillar strategy that involves touring, financing and seller-based solutions. In addition, it hopes to enhance its partner network and further integrate Zillow's multiple services.
Challenged financials
Zillow reported positive but challenged financials for the first quarter of 2023 on May 3. Its revenue of $469 million beat analysts' forecasts by $43 million, but still declined 12.5% year over year.
The business was mainly impacted by a substantial 43% decline in its mortgage revenue to $26 million.
As mentioned prior, I believe this is just a temporary setback and driven by the macroeconomic environment.
Either way, this has not stopped the company from building out a number of tools to bolster its mortgage offering, including a pre-qualified button and estimator calculators.
Rental revenue also grew by 21% year over year to $74 million as people who are not delaying home purchases still require rental options.
Moving onto profitability, the company reported earnings per share of 37 cents on a non GAAP basis, which beat forecasts by 24 cents.
Its raw GAAP earnings per share were still negative at a loss of nine cents, but this was still an improvement over the 30-cent loss reported in the fourth quarter of 2022.
Zillow also has a robust balance sheet with $3.4 billion in cash and marketable securities. In addition, the company reported close to $1.7 billion in convertible debt.
Valuation
Interestingly, Zillow trades with a price-sales ratio of 5.87, which is 36% more expensive than its five-year average.
However, I believe this number may be skewed since Zillow's revenue fell when it exited the iBuying business, but it was lower margin anyway. Also, its pric-esales ratio was over 10 in 2021 and it now trades cheaper than this.
The GF Value Line also indicates a fair value of $43 per share. Based on historical ratios, past financial performance and analysts' future earnings projections, this means the stock is modestly overvalued as of the time of writing.
Again, I believe these details may be slightly skewed, but investors could still wait for a further pullback if they really want an extra margin of safety.
Opendoor
The other company is Opendoor Technologies Inc. (OPEN, Financial), which has become the undisputed market leader in ibuying after Zillow's exit from the market. In fact, Zillow has even partnered with its former competitor in order to enable website visitors to request an offer directly from Opendoor.
Investors may be cautious about Opendoor’s business model given Zillow's success. However, it looks a though its management has learned from their mistakes, making faster inventory turnaround a priority.
Mixed financials
Similar to Zillow, Opendoor reported mixed financial results for the first quarter of 2023 on May 4.
Its revenue of $3.1 billion declined 39% year over year. However, it still beat analyst forecasts by over $378 million.
Its number of listings inside its “buy box” declined 25% due to the macroeconomic environment impacting housing.
The business prudently slowed down its home purchases with just 1,747 homes bought in the first quarter, down 81% year over year.
On a more positive note, seller conversion improved from 10% at the start of the quarter to 15% by the end of March. Futher, Opendoor continued to build out its agency partnerships and reported 50% of its contracts were sourced from this channel.
The company has also continued to roll out its pilot marketplace program, which could be a game-changer for the housing market. This would enable sellers to interact with each other, buying and selling property at a faster rate. This offers immense potential to increase the liquidity in the housing market and, of course, Opendoor will take a cut.
Its Plano, Texas-based pilot was a success with 60% of sellers pitched agreeing to enroll. Opendoor plans to replicate this strategy across different cities and states throughout the U.S., which investors should keep an eye on.
Moving onto margins, the company reported a contribution margin of -7.7% for the quarter.
Further, its loss of 16 cents per share was worse than the earnings of 5 cents reported in the prior-year period. However, it still beat estimates by 44 cents.
Moving onto the balance sheet, Opendoor reported a solid $1.3 billion in cash, cash equivalents and marketable securities, in addition to $459 million of equity invested in its homes. The company did report fairly high debt of $3.9 billion in total, though the vast majority is long term.
Valuation
Opendoor trades with a price-sales ratio of 0.1, which is 97% cheaper than its five-year average.
Therefore, it appears to be trading at a substantial discount due to the tough housing market and its higher-risk business model.
Final thoughts
Both Zillow and Opendoor are leading digital housing companies that are poised to benefit from a rebound in the housing market.
With an experienced management team, I believe Zillow's goal to increase the percentage of property transactions is a fairly straightforward strategy to implement. Opendoor’s model is slightly more risky, but given the lack of competition in this space and due to learning from Zillow’s mistakes, the company could also be a solid long-term investment.
