We are somewhat surprised that there aren’t more people following the results of ZipRealty on a regular basis.  We understand the stock trades almost on a “by appointment” basis, as exemplified by the 2700 total shares that have traded since the company reported results.  However, from a market perspective ZIPR has broader exposure than almost all of the homebuilders.  Last year the company was a top ten residential real estate broker as measured by the number of sides.  The company operates in 36 markets and is on pace to serve as an agent in more than 20,000 home sales this year.  Put another way, the dollar value of transactions that the company works on this year could approach $5 billion, which would give the company 50 bps of total market share in the US.  Outside of filings from Realogy for its bondholders, there are few other ways to gain insight from one of the leading residential real estate brokers in the country. As some of our loyal followers know, we have been recommending shares of ZIPR for some time.   Even though we expect housing to be a tough slog going forward, we feel that ZIPR is well positioned for an environment where volumes have stabilized and the type of non-traditional home sale increasingly comes at a higher price point.   We think the company offered some interesting insights about the state of the housing market in its most recent earnings conference call. 

Takeaways About the Housing Market from ZIPR’s Conference Call

We will discuss our expectations for ZIPR’s revenue and earnings shortly.  First we would like to review some of the key data points we gleaned from the company’s conference call.

1) The number of closed transactions increased 28.5% YOY.  Slower transaction growth in California and Arizona was offset by an increase in volume growth in Texas, the Midwest and the Mid-Atlantic.  ZIPR management’s statements about the shift in transaction growth corroborate data from the California Association of Realtors.  As the chart below demonstrates, YOY volume growth in California has slowed for five consecutive months now.  It is important to keep in mind that the slow down comes at elevated levels – the number of homes sold in California this year is on track to eclipse that in 2006.

Source: California Association of Realtors

The situation in Arizona is not too dissimilar, where the increase in existing home sales slowed from 74% YOY growth in May to 51% in June according to Arizona State Realty Studies.  Not all bubble markets witnessed a slow down in volume in the month of June, both Las Vegas and Florida witnessed a sequential uptick in YOY growth.  Overall, we think investors should increasingly expect a slow down in volumes in former housing bubble states where the lower priced foreclosure properties have been flushed through the system.  We are encouraged that slower volume growth in those markets has been offest by an uptick in volume in non-bubble markets where prices have declined to the point where affordability has once again become very compelling. 

2) According to ZIPR management, inventory of homes declined in every single market in which they operate.  The decline in inventory is a result of two factors: first, a huge reduction in the number of new homes being built nationwide and second, a slowdown in foreclosure activity and a commensurate increase in loan modification work.  ZIPR management talked about the uncertainty created by “shadow inventory”; the large amount of homes for which foreclosure proceedings have not commenced or are currently being held back from the market by banks. Despite the positive news about inventory, we do not foresee a scenario in which we can become constructive on home prices nationally until the inventory of existing homes is reduced by approximately 1 million. As the chart below demonstrates, inventory has declined, but it still is not consistent with levels more consistent with a “normal” housing market.

Source: National Association of Realtors

We anticipate the reduction of inventory could take 2-3 more years, after which home prices nationally could increase again.  The good news is that the rate of inventory reduction is increasing. 

Source: National Association of Realtors

There’s a large dichotomy growing in the marketplace, which is not evident by this chart.  Inventory for lower  priced homes has plummeted. For example, the inventory of homes in California now stands at 4.1 months supply, which is due to the rapid rate of sales for homes that cost less than $300,000.  However the inventory of homes priced above $750,ooo now stands at more than 40 months according to the National Association of Realtors.  Investors are more than willing and able to snap up homes at the $200,000 price point.  In former bubble markets, investors have once again become a meaningful component of the housing market.  According to MD Data Quick, investors accounted for 36% of home sales in June.  Sure sounds like 2005 and 2006. Over the next 6-12 months, we expect an increasingly large number of higher priced homes to enter the foreclosure process.  These are the types of homes entering foreclosure due to job loss or another economic hardship.   The question is: will investors be willing to purchase higher priced foreclosure properties?  We are skeptical, which means it could take longer for those homes to cycle through the market place and inventories could stay elevated for an extended period of time.  Stay tuned.

 3) For the first time in eight quarters, ZIPR witnessed a sequential quarter-to-quarter increase in the average price of home sold.  The average transaction price for ZIPR increased 5.2% from the first quarter to the second quarter.  One might be quick to assume that this is a result of higher home prices.  As is often the case with the data on a national level, the headline numbers do not tell the full story.  As we argued in our post “Housing is the Business Cycle, So Where Are We Now?” there are really three separate markets in housing right now: a) The market for foreclosure/distressed sales, b) the traditional resale (existing home) market, and c) the market for new homes.  Average prices for foreclosure/distressed sales are increasing. ZIPR management talked about an increase in the number of bids on foreclosure properties.  It is also important to note that the mix of the types of homes entering foreclosure is slowly creeping towards a higher price point.  We think the average price of homes sold in the traditional resale market continues to decline as does the price point for new homes.

For ZIPR, it is important to recognize that the mix of non-traditional home sales (aka foreclosure or short sale) has a huge influence on the average price of homes sold for ZIPR.  One could make the argument that the sequential improvement in the average price of home sold is exclusively a function of a reduction in the percentage of non-traditional sales.  As the chart below demonstrates, non-traditional sales declined from 53% in 1Q09 to 43% in 2Q09.

Source: ZipRealty

 ZIPR generates approximately 35-40% of its revenues in California and has a large presence in Arizona.  The change in the percentage of non-traditional transactions provides evidence that foreclosure activity in these states has slowed, which is encouraging.  According to Arizona State Realty studies, the percentage of foreclosure sales in the Phoenix area declined from 40-50% between April 2008 to January 2009 to 30-35% the last 4-5 months.  However, you cannot delay the inevitable and there are a still a large number of homes that are underwater from  a price point with owners that can no longer service the debt (or will be unable to once their mortgages reset).  As a result, we think it is possible that the number of non-traditional transactions could stabilize at current levels, or increase once again in the next 6-9 months.  It is likely these will be higher priced homes, so the median price of homes sold in former bubble states could stabilize at current levels, or even increase, but it is important to understand how the cross-currents in the housing market could create that dynamic.

ZIPR’s Path To Profitability

 From a company perspective, ZIPR’s results were solid.  Revenues and a loss per share of $32.1 million and $0.07 were more or less inline with expectations.  The company added another 183 agents during the quarter, which brings its total agent count to 3,172.  Agent productivity (the number of transactions per agent) was flat on a YOY basis, although an increase in agent productivity in existing markets was offset by a decline in productivity in new markets.  Most importantly, ZIPR was cash flow break even for the quarter.  We think the company is making steady progress towards profitability in the worst housing market in the past 70-years.  The biggest swing factor in the company’s earnings will be the profitability of “new markets”.  Contribution margin (including marketing spend at the local level, but not corporate G&A and product development costs) for existing markets is solid.  For the quarter, existing markets generated $27.1 million in revenues and contribution margins of 17%.  For the year, we expect contribution margins in existing markets to be flat YOY at 13%.

New markets have been a boost to the company’s topline, but a drag on overall profitability.  However, the losses from new markets continue to narrow. During the second quarter, revenues from new markets increased 78% YOY, while the operating loss narrowed from $670K a year ago to $150K this year.  We think contribution margins from new markets are set to turn positive in 2010 as agent productivity improves and the company expands brand awareness.

Source: Company reports, PAA Research

 We think this is a critical inflection point for the company.  Achieving scale and profitabilty in new markets should enable ZIPR to achieve positive operating income within a 12-month time frame.  Structurally, the company’s business model is poised to generate strong free cash flow.  Based on our estimates, the company will end 2009 with more than $40 million in cash, or $2.00/share.  We think it is possible that the company could be free cash flow positive next year, which would position the company to repurchase shares.  ZipRealty is a top ten residential real estate broker, gaining market share and on the brink of turning free cash flow positive.  At an enterprise value of $20 million we think ZIPR shares are highly attractive.  We see upside to the $4.50-$5.00 range and think the company could also be an increasingly attractive acquisition candidate as the housing market stabilizes.

As always, please act accordingly…

Disclaimer:  The author of this report owns shares of ZIPR, positions can change at any time without notice.