Spruce Point Capital Management Announces Investment Opinion: Releases Report and Strong Sell Research Opinion on Zillow Group, Inc. (Nasdaq: Z)
Spruce Point Capital Management, LLC ("Spruce Point" or "we" or "us"), a New York-based investment management firm that focuses on forensic research and short-selling, today issued a detailed report entitled "Zillow's Sinking Foundation" that outlines why we believe shares of Zillow Group, Inc. (Nasdaq: Z) ("Zillow" or the "Company") face up to 40% to 60% long-term downside risk, or approximately $23.00 ? $35.00 per share. Download or view the report by visiting www.SprucePointCap.com for additional information and exclusive updates.
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Spruce Point Report Overview
Zillow Group, Inc. operates a portfolio of real estate-related mobile applications and websites. Its core property is its namesake website, Zillow.com, which is the most visited residential real estate website in the United States. Zillow's Premier Agent program, which represented 62% of 2023 revenue, seeks to monetize Zillow's web traffic, either through advertising products or leads sold to real estate agents on a share of voice basis ("market-based pricing" or "MBP") or to agents on a pay-for-performance basis through the Company's Flex model. Spruce Point believes Zillow's Premier Agent program is facing a crisis. First, the Company's greatest asset, the traffic to its websites, has been in decline for a year now as record high home prices combined with elevated interest rates have dampened home-buying demand. Second, litigation involving the National Association of Realtors ("NAR") threatens to upend the decades-long tradition of broker cooperation, whereby listing agents and buying agents share commissions paid by home sellers. One independent analysis shows that if broker cooperation were eliminated, as many as 80% of real estate agents could leave the industry, and the commission pool could be reduced by as much as 30%. Considering that buyer real estate agents are the core customers in the Premier Agent program, we believe this change could dramatically impact the Company's results. Even if there was no impact from the lawsuits, Spruce Point believes Zillow's core MBP business will continue to be pressured given its maturity and saturation. Third, we believe Zillow's is using aggressive accounting policies to "pre-book" revenue.
The concerns we outline in our report include:
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Zillow's core business model is under pressure from declining web traffic and growing industry litigation and regulatory risks that are poised to disrupt the real estate commission structure. Key indicators show Zillow is experiencing a rapid decline in web traffic, which is the foundation for the Premier Agent business. Zillow has seen a deceleration in both site visitors and unique users since 2021, with growth turning negative in 2023. Additionally, Zillow's measure of its ability to monetize traffic, Premier Agent Revenue Per Visit, has essentially been flat since 2016. Our proprietary research indicates Zillow's core MBP business has become saturated in certain markets, with desirable zip codes across the U.S. sold out. Our research also indicates pricing has little room to grow as lead quality has deteriorated over the years.
Spruce Point believes the ongoing litigation involving the NAR and other MLS operators will have a significant impact on Zillow's core Premier Agent business. Considering the verdict in the NAR case combined with the DOJ's statements in the MLS PIN case, we believe it is more than likely that the NAR and other MLS operators will no longer engage in cooperative compensation to participate in their respective MLS. In other words, home sellers would no longer be on the hook for paying both the listing and buyer agent commission, setting the stage for a situation where home buyers would have to contract with their agents directly, which may lead to agents offering lower rates to be competitive, reducing their revenue and in turn the amounts they are willing to spend on Zillow services. An independent analysis indicates that the end of broker cooperation could lead to as many as 80% of real estate agents leaving the industry. The analysis also suggests that agent commissions could fall as much as 2% and that the overall industry commission Total Addressable Market (TAM) could be reduced by as much as 30%. Spruce Point believes this would dramatically impact Zillow as roughly two-thirds of Zillow's revenue is generated by its Premier Agent program, which has significant exposure to the advertising budgets of agents representing home-buyers under the MBP model and the Flex model relies on the overall number of qualified agents in the industry that can convert leads. Compounding the issue is Zillow's management team, which has proven itself unable to successfully expand beyond its core business. A stream of business failures and restructurings with little accountability shown for those at the top highlights why this business, run by long-time incumbents, offers investors a shortage of viable new growth initiatives. Zillow's Flex/Enhanced Market initiative is ripe with execution risks but no matter how it plays out, lower commission rates or a decrease in the number of qualified agents could ultimately impair this model.
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Homes.com represents an underappreciated and growing threat. CoStar Group (Nasdaq: CSGP), which bought Homes.com in April 2021, recently announced it is investing over $1 billion to market the website, with its slate of four Super Bowl commercials effectively being the launch party. CoStar management describes it as "the biggest marketing campaign in real estate history." For the first time, we believe Zillow will face a well-capitalized competitor. Homes.com has already won a significant web visitor share over the past few quarters, reaching 100 million unique visitors in September 2023. Considering CoStar's deep pockets and management's public desire to unseat Zillow's market leading web traffic position, we believe Zillow investors should take the threat seriously. CoStar has a history of successfully disrupting advertising real estate marketplaces, having previously scaled Apartments.com into the top visited residential rental website. We believe Homes.com will continue to build its web traffic on the back of its historic marketing campaign. In addition, we also believe there is significant potential for Homes.com to further erode Zillow's already declining web traffic, putting even more pressure on the Premier Agent business. Coincident or not, Zillow's new 2024 investor presentation, which was updated last month, removed a key slide provided in 2022 that it expected $5 billion of revenue by 2025.
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We believe Zillow uses various aggressive accounting and financial policies that can enable premature revenue recognition and margin enhancement. Footnotes from Zillow's 10-K reveal that under its Flex program, the Company books an estimate for revenue as soon as leads are sent to agents, despite cash not changing hands until the agents successfully convert a lead, which in some cases can take two years or more and may never happen at all. In fact, Zillow's recent audit report now indicates enhanced focus and testing of Premier Agent revenue. Zillow also books an estimate for revenue upon a commitment for an interest rate lock ("IRLC"). Spruce Point believes these practices require significant management judgement as some consumers may have multiple commitment letters from different banks/vendors. Zillow must estimate a pull-through percentage, which is the probability that an IRLC will ultimately result in a closed loan. A higher estimated pull-through rate allows management to estimate higher revenues. Since 2020, the weighted average estimated pull-through rate used has grown by 10 percentage points. Spruce Point believes Zillow should provide more disclosure around assumptions on the timing and conversion of leads and mortgages. We are concerned that Zillow may be inflating its revenue with unrealistic assumptions, which could have the effect of masking deteriorating fundamentals in its business. We also believe that Zillow's margins and cash flow are significantly embellished with aggressive use of stock-based compensation ("SBC"). Zillow is amongst the most aggressive users of SBC in the public market. In fact, its SBC on a per-employee basis more than doubled between 2020 and 2023. We believe Zillow boosts "adjusted" margins by shifting traditionally cash compensation costs to SBC, allowing Zillow to present strong adjusted EBITDA and earnings, despite languishing cash flows. There is a real cash cost to this practice since Zillow has spent nearly $1.4 billion to repurchase stock to mitigate dilution over the past two years.
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Spruce Point has serious concerns with Zillow's governance and shareholder alignment. Through ownership of the Company's 10-1 voting Class B shares, Zillow's co-founders Rich Barton and Lloyd Fink have total voting control. In the aftermath of the Zillow Offers disaster in 2021, approximately $8 billion of shareholder value was destroyed yet executives came away largely unscathed. In fact, executives even received compensation increases. We also find it concerning that executive compensation is not tied to financial performance and Zillow does not have any formal clawback policy that would enable the Company to recoup compensation given to executives in the event of a financial restatement. Spruce Point believes the voting control paired with exceptionally long-tenured directors has effectively turned the Company's Board into a "good old boys club," especially because four of Zillow's seven independent directors have been on the Board since 2005. As just one example of the persistent entrenchment issues on the Board ? on January 9, 2024, Zillow appointed William Gurley back to the Board after he had previously served from 2005-2015. He currently serves on the Boards of Nextdoor Holdings (Nasdaq: KIND) and Stitch Fix (Nasdaq: SFIX), both troubled public technology companies that have destroyed value.
- We believe Zillow shares present a poor risk/reward with just a 5% upside to the sell-side consensus target while trading at an unwarranted premium to other more fundamentally sound internet businesses. We believe Zillow's core Premier Agent business will struggle amid weak home sales and declining web traffic. While Zillow's rental business has provided a significant lift to growth in recent quarters, we expect its growth contribution to be more muted going forward, especially given Zillow's rental revenue declined on a quarter-over-quarter basis in Q4'23. Sell-side analysts continue to buy into the Company's "Housing Super App" story, which is how we believe Zillow justifies its growth-oriented valuation. However, our independent checks suggest that the Super App is nothing more than marketing fluff drummed up to stoke investor optimism. Considering Zillow's recent history of failed new business ventures, we caution investors against giving Zillow credit for its recent round of promoted growth initiatives. As a result of its languishing core business, dubious growth prospects, growing regulatory threats affecting its broker clients, and questionable earnings quality, we believe Zillow shares present up to 40% to 60% long-term downside risk, or $23.00 ? $35.00 per share.
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Please note that the items summarized in this press release are expanded upon and supported with data, public filings and records, and images in Spruce Point's full report. As a reminder, our full report, along with its investment disclaimers, can be downloaded and viewed at www.SprucePointCap.com.
As disclosed, Spruce Point and/or its clients have a short position in Zillow Group, Inc. (Nasdaq: Z) and owns derivative securities that stand to net benefit if its share price falls.
About Spruce Point
Spruce Point Capital Management, LLC is a forensic fundamentally-oriented investment manager that focuses on short-selling, value and special situation investment opportunities.
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