Redfin IPO Too Hot: Caution Advised


Redfin (Pending:RDFN), the next-gen real estate broker that claims to use superior technology to cut commissions and closing costs, popped in its first day of trading on July 28. Investors embraced the company’s strong narrative, endorsing the idea that real estate is one of the final swaths of industries ripe for “Uber-ization.”

This much is true. But at what cost?

Redfin plays up the technology angle in its S-1 filing, and while it is indeed a technology-enabled company, it makes money the old-fashioned way: collecting commissions on real estate transactions. And, what’s more, in its efforts to win customers and establish market share, it charges only half the standard broker commission, earning 1.5% upon the sale of a home versus the standard 3%.

While this is a huge win for customers, it’s a major concern for investors. If Redfin does indeed scale to a massive size, then, volume will make up for the reduced commissions (the “Wal-Mart approach”). But scale in an industry as fragmented and localized as the real estate market will take years to achieve, and high costs and execution risks litter the path to growth.


Redfin is an exciting company with a revolutionary narrative, but investors are cautioned to stay on the sidelines until the stock falls to a more reasonable entry point.

Redfin Basics

Redfin was founded in 2004 as a digital-first real estate brokerage, providing a web-based real estate database and machine learning tools to efficiently pair buyers and sellers of homes, theoretically raising the productivity of Redfin real estate agents (called “lead agents”). These productivity gains are in turn shared with consumers, in the form of closing cost rebates for homebuyers and commission discounts for sellers.


Below is a screenshot from Redfin’s website showing projected savings for an average home sale:

Redfin Customer Savings
Redfin’s sell-side lead agents charge only a 1.5% commission (allowing home sellers to pay only 4.5% of their total home value at closing), and in some hyper-competitive markets, it charges only 1% (Chicago, Seattle, and Denver). On the buy-side, Redfin still earns the typical 3% fee paid by the home seller, but refunds a portion of this money to its customer in the form of closing cost deductions.


This is a major win for the consumer. Not so much for the investor. Real estate is already a low-margin business, and these discounts cut directly into Redfin’s bleeding bottom line.

Some stats: as of March 2017, Redfin employs 935 lead agents across 84 markets. In 2016, Redfin lead agents closed 33,350 transactions with a total value of $16.2 billion, an approximate market share of 0.58% in the U.S. real estate industry. In March 2017, the Redfin website drew an average of 20 million unique site visits, about an eighth of Zillow’s (NASDAQ:Z) 167 million during the same time frame.


Redfin’s lead agents, whose commissions are counted in the company’s cost of revenue, “earned on average twice as much money as agents at competing brokerages,” according to Redfin’s S-1 filing. This is due to Redfin’s compensation model that includes a higher base salary component and places lesser emphasis on commissions.

So, not only do we have a company that discounts its services for consumers but also one that has significantly higher personnel costs. This is a remarkable company for customers and employees, but its business model should give investors pause.


Growth Pitfalls

Like every tech IPO, Redfin has posted strong growth numbers. The billion-dollar question is: can that growth continue, and is it sustainable from a profitability standpoint? Below is a chart of Redfin’s key financials and business metrics since it began disclosing numbers in 2014:

Figure 1. Redfin key metricsRedfin financials
Growth above 40% is certainly impressive, and the operating margin seems to have slimmed to thinner losses in 2016. Note that the first quarter is seasonally slow for real estate transactions, so Redfin’s Q1 gross margins are not indicative of full-year margins as it must continue to pay lead agent salaries while earning fewer commissions.


However, growth will be difficult for this company to sustain. The real estate industry is highly fragmented, with each local market prone to its own quirks – documentation, title, property taxes, and the like. It’s relatively easy for a software company to sign a big new deal with a new firm in another area (or for that matter, in another country entirely), but it’s not easy for Redfin to launch brokerage activities in new markets. Locals in those areas likely already have strong brand familiarity with the real estate brokerages they see littered on yard signs around their neighborhood. Developing a brand presence in real estate takes time, particularly because it’s often the largest transaction in an individual’s financial life, and entrusting it to a startup is a difficult obstacle to overcome. To fuel growth, Redfin has advertised lower commissions; and to hire talent quickly in new markets, it has paid high base salaries – both aggressive actions that hurt the top and bottom lines.


And, notice Redfin is only grabbing market share very slowly, adding a tenth of a percentage point each year. Granted, the real estate market is very large and difficult to crack, so those tenths of a point represent large numbers. But in any case, this is not a category-defining tech company that swoops in and immediately grabs the lion’s share, like Uber (Private:UBER). So, it shouldn’t be valued like one.

Let’s also briefly consider dynamics in the wider real estate industry. Record-low housing inventory has made headlines this year, meaning much fewer real estate transactions. A report from Trulia claims that housing inventory in 1Q17 is down 8-9% from the prior year.


Even Redfin’s CEO, Glenn Kelman, acknowledged in a CNBC interview that low inventory is hurting Redfin: “It’s never declined faster than it did last month. It’s freaking us out – it’s affecting our business; it’s limiting our sales.”

IPO investors only want to hear about growth, growth, growth. Slowing secular trends do not set Redfin up well for its first few reporting quarters as a public company, and even if it manages to set expectations well, investors are likely to be disappointed in the growth numbers.


Competition

Let’s also discuss the other elephant in the room: competition. Real estate is a very competitive business, and Redfin does not have sole dominion over web-based real estate search. Virtually, every real estate broker now has some sort of presence online.

Examining Redfin’s two publicly traded comps – RE/MAX (NYSE:RMAX) and Realogy (NYSE:RLGY), which owns old-school, venerable brands such as Century 21 and Coldwell Banker – we see that these companies are reliably generating profits and EBITDA, and that they are trading at reasonable multiples thereof.


Figure 2. Redfin operating compsRedfin Comps
Redfin might be posting tech-company growth, but the obstacles previously discussed prevent it from truly exploding. Unlike software companies and advertising-based internet companies that post gross margins in the 70s and 80s and can scale quickly to profitability if they choose, Redfin has extremely slim gross margins, thanks to the high salaries it pays to its lead agents. Thus, it should not trade at high-flying revenue multiples like the rest of the tech sector; it should trade more like a real estate broker. And, even in that arena, where earnings are king, Redfin has yet to show one quarter of profitability.


Conclusion

Redfin is actually a fantastic company, just not a great stock to own at this point in time. Real estate will be disrupted by technology in the near future, and Redfin is one of the key players leading that disruption.

But it’s important to realize that even though Redfin employs cool technology and uses buzzwords such as “machine learning” in its S-1, it makes money like a good old-fashioned real estate broker, which is a hyper-competitive market with low margins as well as secular headwinds. The stock has already priced in years and years of growth that may not materialize, and its current price point carries a high degree of risk.


Investors in recent days have already treated consumer tech stocks frigidly, sending shares of Snap (NYSE:SNAP) down 43% and Blue Apron (NYSE:APRN) down 33% from IPO levels. It didn’t take long from the initial pop for those stocks to come crashing down to earth.

I’ll caution investors from going long immediately on RDFN; I would prefer to wait on the sidelines until a negative catalyst (missed earnings or the lockup expiration in January) drives the price down.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.

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