Anyone who was overly surprised by Zillow's (Z) stock fallout after their second quarter results hasn't been paying attention.
The headlines are connecting the dots to their announced acquisition of a mortgage company, but there's more to it than that. The company has taken on a lot of liabilities, while shareholders have waited for profitability. This new acquisition is simply adding to the debt. Will it serve their business interests? Absolutely it will.
Is the company very close to producing quarterly profits? It certainly seems so, but the ramifications of those profits on earnings per share basis don't justify the stock price that the market has become accustomed to.
That's what you're seeing in the correction right now. The shares retreated over 16% on Tuesday.
To their credit, Zillow did beat estimates. Their second quarter results included a 22% increase in total revenues. That $325 million was mainly driven by a 40% improvement in rentals and a 22% increase in revenues from premier agents. Despite coming close, the big increases in expenses still blocked Zillow from profitability. Sales and marketing increased 13% to $147.7 million, while technology and development expenses rose 28% to over $100 million.
The company noted that most of their increased expenses rose from competing for tech workers who can facilitate their operations.
There are a lot of different companies trying to get their hands on the good recruits. General and administrative costs were up 14% to $60.6 million. In all, Zillow came very close to showing some positive net income. The total net loss for Q2 was $3.1 million. On a non-GAAP basis they earned $0.13 per share. GAAP included, which is the only thing that matters, they reported a loss of $0.02 per diluted share.
On the surface, you might be saying "Well, this is great! Zillow is almost profitable."
Yet when you look at what's happening on the balance sheet in terms of debt, and to the stock in terms of dilution, I'm just not that excited yet. Zillow's shares had a great deal of expectation baked into them. Forecasts are putting the company's full year earnings at $0.65 a share. Even at that apparent non-GAAP income, the stock is trading at over 70 times forward earnings even after today's 16% plummet.
I don't even need to say more about how overpriced that is. Next year's estimates are right around $1 a share. Even if they exceed those levels by a little bit, we're talking about a 40 timespremium.
The liabilities kill me
The loss per share would have been bigger were it not for the ever-expanding number of shares outstanding. Total weighted average shares increased 4.7% year over year to 194,155,000 shares outstanding. That might not seem like much, but the shares keeping growing year after year while the stock price has been allowed to run higher and higher, diluting investment potential. The other source of financing has been debt. Long-term debt at the end of the second quarter was $394.42 million. The quarterly interest payments are rising from these sort of liabilities, and I worry that the trend will continue.
I've been complaining about the adverse effects that would ensue from acquisitions and debt without organic sources of income for awhile. The downgrades taking place today are finally in line with what I've been saying. I would argue that these downgrades in the $50s, and Merrill Lynch's $60 a share, are still too high.
For all intents and purposes, Zillow is just an advertising company. They're the same as every other online business. Now that they're jumping into more complex businesses like mortgage lending, and buying/selling houses, we're looking at a big boost in costs and risk. Bank of America Merrill Lynch has noted the higher risks for next year, and has downgraded the stock to a hold.
The combination of a changing business model, overvalued stock price, and rising debt levels is a cocktail for headaches. It's clear that Wall Street is finally starting to acknowledge that. Until earnings start moving, and the company demonstrates that it can handle the much heavier workload associated with buying/selling real estate itself, I see Zillow falling more rather than going up.
I reiterate that this stock pullback is not something that should surprise. The company hasn't created earnings for shareholders. They're spending more money to try and diversify the business model; most likely because it's such a hard model to create big profits in.
Competitors like Redfin (RDFN) have also struggled this year, and it's indicative of the overvalued nature of this digital real estate space. Obviously it's an innovative concept that has big merit, but investors have simply run it too high too fast.