Zillow, the Next Great Aggregator?
As investors we are always on the lookout for companies with an edge that gives them the potential to dominate in a systematic and predictable way. There are many methods one can use to identify such companies but my favorite is Aggregation Theory. Last month I wrote about Spotify and its journey to Aggregator status. Spotify's biggest roadblock is its reliance on record labels for supply and the devastating impact that has on music streaming margins. While I am optimistic that Spotify can use its direct relationship with the end user as leverage over the record labels, it's going to be a long uphill battle before the company becomes an Aggregator.
I was recently asked which company available in the public markets is the most undervalued when looked at through the Aggregation Theory lens. My answer was Zillow so I thought I'd write what will likely be the first in a series of posts on the company. But first I'll let Ben Thompson, the father of Aggregation Theory, provide the quick refresher on what makes an Aggregator (via Stratechery):
Aggregators as a whole share three characteristics:
A direct relationship with users
Zero marginal costs to serve those users
Demand-driven multi-sided networks that result in decreasing acquisition costs
This allows Aggregators to leverage an initial user experience advantage with a relatively small number of users into power over some number of suppliers, which come onto the platform on the Aggregator’s terms, enhancing the user experience and attracting more users, setting off a virtuous cycle of an ever-increasing user base leading to ever-increasing power over suppliers.
Not all Aggregators are the same, though; they vary based on the cost of supply:
Level 1 Aggregators have to acquire their supply and win by leveraging their user base into superior buying power (i.e. Netflix).
Level 2 Aggregators do not own their supply but incur significant marginal costs in scaling supply (i.e. Airbnb or Uber).
Level 3 Aggregators have zero supply costs (i.e. App Stores or social networks)
When Zillow IPO'd back in 2011 it was touted as the company poised to disrupt the real estate industry. Zillow generates most of its revenue via advertising, which means high gross margins. Investors like those. In the last seven years Zillow has impressively scaled its ad business by building a consumer-facing real estate database. What I think most people fail to recognize is that Zillow is not currently in the real estate business but rather a media company tangent to the housing market. Because most of its revenue is driven by getting real estate agents to advertise their listings on the site, Zillow is excluded from the most valuable aspect of the real estate business... the actual home sale! The harsh realty is that Zillow operates as a glorified lead generation tool for real estate agents, nothing more than a realtor marketing expense and while that has been a lucrative business, it is not a disruptive one.
Then something interesting happened. Zillow announced that it would entering a new market, effectively pivoting its entire business model (via CNBC):
Zillow shares plunged 9 percent on Friday after the online real estate database company announced it will begin buying and selling homes, a capital-intensive endeavor. With Zillow’s new program, announced on Thursday, home sellers in the test markets of Phoenix and Las Vegas will be able to use Zillow’s platform to compare offers from potential buyers — and Zillow. When Zillow purchases a home, it will aim to quickly flip the home, making updates and repairs and listing it as soon as possible. An agent will represent Zillow in each transaction.
We’re entering that market and think we have huge advantages because we have access to the huge audience of sellers and buyers,” Zillow CEO Spencer Rascoff said on CNBC’s “Squawk Alley.” “After testing for a year in a marketplace model, we’re ready to be an investor in our own marketplace.”
But investors are less enthusiastic. Flipping homes, a model that’s being utilized by start-up Opendoor, is very different than operating an internet marketplace. It carries additional risk associated with buying and selling homes and requires a hefty investment in operations. And it also potentially puts Zillow in direct competition with the realtors on its platform. Zillow sank $5, or 9.3 percent, to $48.77 as of mid-day on Friday, knocking more than $900 million off its stock market value.
To be fair, what Zillow is trying to do carries massive operational risk but one could argue that there is even more risk in continuing along with the status quo. Because let's be honest, the real estate industry is completely fucked.
Home transactions are collectively frequent (there's always at least one house for sale in your neighborhood) but for individual buyers and sellers, they are an extremely rare life event. Most people only go through the experience a handful of times. A home is usually the largest transaction most buyers and sellers undertake, which makes people understandably risk averse. There are also many regulations and a shit ton of paperwork associated with the process so assistance is quite valuable. However that assistance is not free and people pay it in the form of fees. The United States alone has $25 trillion worth of housing, of which $900 billion changes hands every year. That means well over $50 billion in real estate fees, which is mostly captured by agents skimming 6% off of every transaction.
There is a massive reward for disrupting the status quo and becoming a market maker for the broken real estate industry. That is Zillow's opportunity.
The company can't come right out and say they are looking to replace real estate agents because, as we have already established, Zillow generates basically all of its revenue selling advertising space to those same real estate agents. Instead Zillow has said it will handpick agents to work on these new transactions called Zillow Instant Offers. When you want to sell your house the company will make you an Instant Offer based on its trove of housing data massively simplifying the home selling process. Remember, it is sellers who are most disadvantaged in the current process. The agents associated with these quick-flip transactions are non-vital as the transaction is almost entirely powered by Zillow's database.
The real risk that the company faces in its pivot from marketing tool to market maker is that real estate agents will revolt and no longer advertise properties on Zillow. However we have years’ worth of evidence that agents will do what it takes to ensure their listings appear on Zillow, because that's where the buyers and sellers are.
It appears likely that realtors have no choice but to continue giving Zillow the money the company needs to complete its pivot and disrupt the real estate industry. The only question that remains is how much power comes from being an Aggregator and how much value can Zillow capture when that power is wielded?
As you can see on kidkapital.com, I have started to build a position in Zillow.