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Redfin (RDFN) is an extremely favorable long-term investment. I believe over the course of this decade, Redfin should experience a massive increase in market share for its core business. Similar to Amazon (AMZN), as its market share grows, I anticipate that Redfin’s business will become more cost-efficient, offer better products to consumers, and increase profitability.
The first half of this article will explain Redfin’s history and business model for those without a prior knowledge of the company. The second half will focus on analyzing Redfin’s financial statements and 2020 outlook.
The Redfin Business Model
Redfin was initially founded solely as a Real Estate technology company. They invented the first map-based internet real estate search service, which evolved into the popular app and website that we all know and love today.
Like Zillow (Z), Redfin began to generate revenue through advertising on its highly visited properties, as well as through agent referrals. For example, an independent agent might pay Redfin for her name to appear prominently on the app, so a potential buyer may contact her as a client. This is what I will refer to as the “Zillow Model.” In essence, creating a superb digital platform for consumers, and having third party real estate companies and agents pay to capture those consumers on your platform and provide their services.
The “Redfin Model” is wholly more ambitious, and potentially more lucrative. Rather than subsist solely on advertising from third-party real estate brokers, Redfin CEO Glenn Kelman started a real estate brokerage within Redfin, and began to hire brokers to work directly for the company. If we think about this through the lens of Amazon, we can see the financial acumen of the decision. Jeff Bezos is famous for the quote “Your margin is my opportunity.” He sees other people making money, and is willing to go after that profit for himself. Why let Procter & Gamble (PG) sell razors at $10 a box on the Amazon website, in exchange for a 50-cent fee, when Amazon can create its own private label brand and sell the same box of razors for a $4 profit? Glenn Kelman saw a similar situation, and began to capitalize on it.
At this point, Redfin could have established a traditional brokerage. One where the real estate broker gets a 3% commission on every transaction and the brokerage company takes a piece of that commission. However, Glenn Kelman identified a larger opportunity. Rather than hire brokers and take a portion of their commission, Kelman decided to hire real estate brokers on salary, with Redfin taking the entirety of the commission. With control over what commissions should be offered to consumers, Kelman set Redfin’s commission percentage to only 1% to buy and sell versus the market rate of 3%.Source: Redfin Investor Presentation]
Gaining Market Share
With such a low commission percentage, Redfin will save the average person thousands of dollars when buying or selling. This is not by accident, Kelman intentionally set pricing at this level in order to gain market share. This is because market share increases will lead to a positive feedback loop of more sales and more profitability for Redfin. When we think about this through the lens of Redfin’s cost structure, it pays a hefty upfront price to build new technology and hire new brokers on salary. Thus, Redfin’s cost structure has a high level of fixed cost. However, since those brokers are compensated on salary, its variable cost is quite low for any new transaction. This means that incremental revenue is extremely profitable, so the business should operate with a high degree of operating leverage as it grows.
Next, let’s turn our attention to the competitive landscape between Redfin and traditional brokerages. Quite simply, as Redfin grows nationally, industry participants will be forced to lower their prices in order to compete with Redfin, or lose transaction volume in order to retain margins. If industry participants don’t price match, volumes will decline and Redfin’s revenue will grow enormously. If industry participants do price match, they would see a ~50% drop in revenue, overnight on every transaction. For the average real estate broker making $80,000, this would cut earnings to $40,000 and cause a mass exodus from the industry. For the traditional brokerage company, this will mean a ~50% drop in revenue for every deal, before brokers start leaving the industry. This will leave most brokerages structurally unprofitable and without the adequate financial resources to compete, fueling even more volume for Redfin.Source: Redfin Investor Presentation]
Innovate Ancillary Products
Aside from the virtuous cycle the core Redfin broker business will create, I believe Redfin’s true dominance will be exemplified by its technology enabled ancillary services. What does this mean? Aside from paying for real estate brokers, consumers also pay for Mortgages, Title Insurance, Home Insurance, Home Warranties, Inspections, and more. All of these businesses are currently dominated by third party vendors, but represent a huge market opportunity for Redfin.Source: Redfin Investor Presentation]
Mortgage origination is an extremely large and profitable industry in its own right, but attaining a mortgage in today’s regulatory environment is both time-consuming and costly for consumers. By bringing operations in-house and creating a digital solution, Redfin is working to speed up the mortgage process, drive cost efficiency, and leverage its data analytics capabilities to ensure quality issuance on each deal. In fact, Redfin just announced new expansion plans for its mortgage service, which will now cover 20 states. By leveraging its core broker business, I expect Redfin Mortgage to become a successful third party service over time as well, which will outcompete existing competitors that lack its scale and digital presence.
2020 Financial Picture
Redfin entered 2020 with sharply accelerating revenue growth, a rate-cutting environment from the Federal Reserve, and a burgeoning millennial cohort looking to buy homes. It therefore comes as no surprise that its stock price was also at an all-time high. However, with the country descending into lockdown in March, things seem dire for Redfin. States and municipalities banned open houses and showings in tenant occupied properties. Lenders such as JPMorgan (JPM) and Wells Fargo (WFC) began to tighten their mortgage lending standards. Millions of potential clients lost their jobs. All these factors led to a steep drop in the ability to buy and sell real estate, resulting in Redfin furloughing 7% of its staff and lowering compensation to weather the storm. The stock, with the rest of the market, fell precipitously. However, since that time, Redfin has outperformed the market by over 100%, so what changed?
First and foremost, Redfin was able to rely on the strength of its balance sheet. The company ended Q1 2020 with $288M of cash and cash equivalents, which is enough to fund more than two years of operations at its current operational FCF burn rate of $103M per year. Despite its relatively comfortable liquidity position, Redfin bit the bullet and issued additional shares on April 1st 2020. The capital raise sold 40,000 preferred shares at $1,000, raising $40M and an additional 4,484,305 of common stock shares at $15.61 raising $70M. With immediate liquidity concerns resolved, investors turned their eyes to the state of the real estate market.
Although many analysts feared an impending real estate crisis similar to 2008, real estate activity actually remained surprisingly strong. Home prices continued to increase throughout the pandemic and have since rebounded from their low point. Homebuilder confidence has also surged back to pre-pandemic levels, and to top it off, home sales have officially exceeded pre-pandemic levels. As Glenn Kelman recently stated on CNBC, the continued low-interest rate environment in the American economy is the strongest tailwind for the real estate sector. Quite simply, over the past 90 days, the cost of buying a $250,000 house with a standard 30-year fixed mortgage has fallen by over $20,000 over the life of the mortgage due to the drop in mortgage rates. As shown below, homebuyer demand has simultaneously surged, as people look to lock in those cost savings.
For two decades, investors watched from the sidelines as Amazon became a bigger, better, more valuable company, all while remaining “overvalued” by valuation metrics. Investors underestimated its long-term growth prospects and overestimated the relevancy of its short-term financial unprofitability. I am determined not to make that mistake.
Redfin is currently a $3.8B company with a share price of $38.80. It did $30B of real estate sales volume in 2019 (18% growth), which drove $779M in revenue (60% growth). Over the next ten years, I model a convergence of the revenue growth rate to the annual 18% real estate transaction volume growth rate. This is despite the fact that revenue growth has actually been accelerating, reaching 73% YoY quarterly growth, which makes this analysis quite conservative. Using this methodology, we see a path for Redfin to expand revenue to $5.8B per year by 2029. Assuming Redfin can maintain its current P/S ratio of 5 times, this results in a Market Cap of $29B, and a share price of ~$300 (23% CAGR).
From a shorter-term perspective, Redfin’s stock has rallied significantly, but there is still room for continued gains. Buried within the Q1 2020 10-Q, Redfin demonstrated that it has finally reached an inflection point in its business model. Throughout Redfin’s history as a public company, it has invested aggressively, which has dramatically increased operating expenses as employees are hired to create new products and enter new markets. Additionally, this has led to ever greater rates of operational cash flow burn, as those expenses precede the revenue that follows.
However, in Q1, Redfin was able to increase revenue 73% and increase gross profit by 468%, all while holding its operating expenses flat. This is something that has never happened in Redfin’s history and shows how powerful its business model can be. On a go-forward basis, now that Redfin’s operating expenses have stabilized, every incremental dollar of gross profit growth will fall to the bottom line.
Modeling this phenomenon out, assuming a flat gross profit margin of 20% and linearly increasing operating expenses of $20M per year, we see that Redfin will reverse its 3-year trend of increasing losses, and actually achieve break-even profitability. From a valuation standpoint, if we apply a P/E multiple of 35x earnings, (for a company we’re expecting to grow earnings and revenue at 20%), we would expect a valuation of $27.7B resulting in a share price of $281.
Although the revenue and earnings outlook appears favorable, there are some skeletons buried in Redfin’s 10-K; chiefly, concerns about the quality of that growth. In 2019, Redfin’s revenue increased $292M. Of that, $195M came from its “properties” division and $91M came from its real estate services division, with the rest categorized as “other” revenue.
[Source: Q1 2020 Redfin 10-Q]
The problem with that growth is that Redfin’s “properties” division, which buys and sells houses, generated no gross margin, in fact it lost money. Redfin did $240M of sales and had $244M in Cost of Sales, generating a loss on operations of $4M. Although this is definitely an area of concern, the properties business is a new business segment experiencing rapid growth. Redfin’s management needs time to build its network and technology, so it can profitably monetize the arbitrage opportunity that exists in the market.
Another caveat to consider is that the properties division only recognizes revenue related to the sale price of the properties, meaning the broker’s commission earned by Redfin is represented elsewhere on the income statement. In this way, Redfin has the ability to drive real estate transaction volume on its own, which can drive profitability through its mortgage and brokerage services.
I believe Redfin’s competitive advantages in the real estate service sector are beginning to bear fruit in the form of increasing revenue growth and increasing gross profit growth. Its operating expenses have moderated, and its operating cash burn has been steadily decreasing. This presents an interesting entry point, since the company will swing from increasing losses to increasing profits in a short time span.
Disclosure: I am/we are long RDFN. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Source: Seeking Alpha