Zillow Group, Inc. — Q3 2018 Form 10-Q
Business context and period. Unaudited results for the quarter and nine months ended September 30, 2018. Zillow operates real-estate marketplaces and professional marketing services (Internet, Media & Technology, or IMT) and began buying and reselling homes through Zillow Offers in 2018. The company reported IMT and Homes as separate segments beginning in Q2 2018.
Financial performance
| Metric | Q3 2018 | Q3 2017 | Nine months 2018 | Nine months 2017 |
|---|---|---|---|---|
| Revenue | $343.1m | $281.8m | $968.2m | $794.5m |
| Operating income (loss) | ($10.3m) | $14.7m | ($31.3m) | ($0.6m) |
| Net income (loss) | ($0.5m) | $9.2m | ($22.2m) | ($17.2m) |
| Adjusted EBITDA | $66.2m | $71.0m | $168.5m | $165.5m |
| Operating cash flow | Not provided for quarter | Not provided for quarter | $102.5m | $176.9m |
Revenue mix and growth: Q3 IMT revenue was $332.1m; Homes revenue was $11.0m, from sales of 36 homes at an average selling price of about $306,100. Total Q3 revenue increased 22% year over year. Premier Agent grew 18% to $232.7m, Rentals grew 31% to $37.3m, Other grew 23% to $43.6m, while Mortgages fell 12% to $18.4m. For the first nine months, revenue grew 22%; Premier Agent grew 21%, Rentals 35%, Other 28%, Mortgages declined 9%, and Homes contributed $11.0m.
Margins and expenses: Q3 operating margin was approximately -3.0%, versus 5.2% a year earlier. Costs and expenses rose 32% to $353.4m, faster than revenue, reflecting increased staffing, marketing and technology investment, alongside a $10.0m impairment. Homes incurred a $15.6m operating loss in Q3 on $11.0m revenue; IMT recorded $5.3m operating income. Q3 net loss was nearly break-even partly because of a $14.7m income tax benefit. Adjusted EBITDA is a non-GAAP measure and excludes, among other items, stock compensation, interest, taxes and impairment.
Cash, liquidity and debt: At September 30, cash and cash equivalents were $643.8m, short-term investments $999.2m, and restricted cash $3.2m; combined liquidity was $1.646bn, compared with $762.5m at year-end 2017. Current assets were $1.795bn and current liabilities $153.2m. Nine-month operating cash flow fell to $102.5m, with working-capital uses including $43.3m of home inventory and $32.1m of contract-cost assets. Investing used $641.8m, mainly net investment purchases; financing provided $834.2m, primarily from equity and convertible-note offerings. Long-term debt carrying value was $690.3m, plus $24.7m outstanding on the revolving facility; convertible-note principal was $843.4m. The revolving facility had a $250m maximum capacity but only $25m current borrowing capacity, of which about $24.7m was drawn. The company stated cash and investments should fund operations and capital needs for at least 12 months.
Material changes and notable items
- In July, Zillow raised approximately $360.3m net from a Class C share offering and $364.0m net from issuing $373.8m principal of 1.50% convertible notes due 2023; $29.4m of note proceeds funded capped calls. The share issuance increased outstanding Class C shares.
- It adopted the new revenue-recognition standard in January 2018. Capitalization of qualifying sales commissions created $45.2m in contract-cost assets at quarter-end and reduced reported nine-month net loss by $3.7m versus prior accounting.
- A $10.0m non-cash impairment reduced a 2017 private-company investment’s estimated fair value to zero.
- On October 31, after quarter-end, Zillow acquired Mortgage Lenders of America for approximately $65m cash. Management expects a Mortgages reporting segment beginning in Q1 2019 and said the business could materially affect 2019 results, balance sheet and cash flows. The acquisition includes warehouse credit lines used to fund mortgage originations.
Outlook, commentary and risks
- No numerical earnings or revenue guidance is provided. Management expects ongoing expense growth as it expands sales, engineering, Homes and marketing operations; it also expects Zillow Offers and mortgage lending to require significant capital.
- Management expected nationwide rollout of a revised Premier Agent lead-validation and distribution model by year-end 2018. It warned that fewer but higher-quality leads could increase advertiser churn and negatively affect Q4 Premier Agent revenue. A separate performance-based pricing test for select Premier Brokers began in October.
- Mortgage revenue faced pressure from lead-distribution changes and higher mortgage rates, which reduced refinance leads; management said future rate effects were uncertain. MLOA is expected to add mortgage revenue, but also increase costs and introduce loan-funding, repurchase, compliance and interest-rate risks.
- Zillow Offers is a new, cash- and inventory-intensive business with limited operating history. Home valuation, renovation costs, resale prices, market conditions, defects, and holding periods could differ from estimates. Homes under contract but not yet closed totaled $30.3m.
- Key broader risks include dependence on Premier Agent (68% of Q3 revenue), advertiser retention and pricing, competition, real-estate market and interest-rate changes, regulation, data quality and cybersecurity, and execution of acquisitions and new businesses. A $4.1m liability was accrued for the VHT copyright case; a securities class action dismissal was granted in October, subject to plaintiffs’ opportunity to amend. The filing says management could not estimate losses for certain other proceedings.
- The company expects a significant balance-sheet effect from adopting lease accounting on January 1, 2019, primarily recognition of office lease assets and liabilities. Disclosure controls were assessed as effective at September 30, 2018.
Important facts for investors to verify
- Whether Premier Agent lead-quality changes cause the forecast advertiser churn or revenue pressure, and how performance-based pricing tests develop.
- Homes unit economics: acquisition and renovation costs, resale margins, inventory turnover, contracted purchases, and the scale and funding terms of the credit facility.
- MLOA’s contribution to revenue, costs, cash requirements, warehouse borrowing, loan-sale performance and regulatory or repurchase exposure.
- Underlying operating trends versus non-GAAP Adjusted EBITDA, including the effects of share-based compensation, commission capitalization, impairment and tax benefits.
- Debt principal, conversion/dilution exposure and liquidity needs as Zillow expands home purchases and mortgage originations.