Opendoor Is The Ultimate Stock For A High Inflation Environment

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Introduction

In reaction to the coronavirus pandemic, central banks across the globe pumped tons of liquidity into their economies over the last two years. A combination of supply chain issues and loose monetary policy has led to multi-decade high inflation. With inflation hitting multi-decade highs, equity market investors seem to have panicked, with several growth stocks down ~50-90% from their highs and broader indices heading towards a correction.

U.S. Bureau of Labor Statistics

Recently released data for Q1 2022 GDP of -1.4% y/y is raising fears of stagflation (a period of high inflation and low economic growth). Historically, real estate has outperformed stocks and bonds during stagflationary periods. As shown in the image below, home price growth was higher than inflation despite rising interest rates (Volcker regime).

Re:Venture Consulting

Today, US House Price Index sits at a record high of 358 with y/y growth of 19.4%. Such incredible moves in the housing markets are the result of a housing supply crunch, record-low mortgage rates, and wage inflation.

YCharts

Most people would agree that owning physical assets during high-inflationary periods is the way to go. That’s what’s worked historically and has been working well in 2022. However, most retail investors can’t afford to buy investment homes, and if they could, the hassle of being a landlord is too much. As such, REITs seem like an easy bet to make in this environment. The problem is most market participants recognize this space, so the alpha is likely to be minimal. Additionally, REITs could become horrible investments if the real estate market goes into a downturn.

With the premise of higher inflation for longer (as discussed in my economic outlook for 2022), I would like to propose a lesser-known alternative to participate in the real estate bull market. My favorite stock for a high-inflation environment is Opendoor (NASDAQ:OPEN). Why?

Opendoor is a real estate market-maker that’s likely to generate higher margins during periods of higher inflation (and positive home price appreciation). If inflation stays elevated, home prices will likely continue to go higher, which will keep Opendoor’s gross margins elevated and boost profitability. For more than 20 quarters in a row, Opendoor has maintained a positive contribution margin, i.e., its unit economics are positive.

Opendoor Q4 2021 Earnings Release

Let’s compare Opendoor’s business versus REITs at the unit level:

1) A typical residential REIT would yield 6-12% in rental income, and the REIT’s assets would appreciate by ~5-10% per year in a high inflation environment. The total return would be ~10-22%.

2) Opendoor’s average holding period of less than 120 days means it can turn over its assets three times per year. If we assume a gross margin of 7-15% per transaction, Opendoor could essentially generate gross profits of 21-45% on its capital. After factoring in variable costs, Opendoor could still generate ~20-25% contribution profits on its capital. The total return generated by Opendoor would be superior to a typical REIT.

In a bear market, Opendoor’s margins would likely compress; however, a residential REIT would lose value too if home prices decline. According to common sense, a real estate market-maker should perform better than a REIT (asset owner/bagholder) in a bear market. Hence, I would prefer Opendoor (market-maker) over REITs in all macroeconomic environments.

Inflation Is A Significant Tailwind, And Estimates From Datadoor Make It Clear

According to proprietary estimates from Tyler Okland’s Datadoor.io, Opendoor is set to record revenues of $5.2-5.4B in Q1 2022 (roughly 20% higher than management’s guidance) with gross margins of 9.7-10.5% (~200 bps higher than consensus estimates). In previous quarters, Tyler’s estimates for Opendoor have been much closer to actual results than management’s guidance and consensus analyst estimates.

Datadoor.io

Tyler and his team have done an incredible job on Opendoor in recent months, and now they are compiling institutional-grade data for iBuying, which is now available on Datadoor.io.

Please feel free to check it out. Special thanks to Tyler for allowing me to share these estimates. Also, I have been estimating ~$18B in revenue for 2022 since the start of this year, and it seems my estimate will probably end up being too conservative. I am very excited to see what Opendoor reports for Q1, and in my view, profitability guidance will be of utmost importance here.

An Alternative Way To Think About Opendoor

Some critics have lambasted Opendoor’s business model due to the inherent risks of carrying housing inventory on its balance sheet. However, in a high inflationary environment, Opendoor’s balance sheet structure makes it a very attractive investment. If we take a big picture view, Opendoor essentially owns ~17K houses worth ~$6B, with an equity position (net cash) of $2.2B. As house prices appreciate, the value of Opendoor’s inventory goes up, and its debt gets inflated away. Hence, Opendoor could be thought of as a leveraged bet on the housing market.

Opendoor Q4 2021 Earnings Release

If you are unsure about buying Opendoor as a market-maker, think of it as a single house. Currently, Opendoor is trading at $5.2B with $2.2B in net cash. Let’s say Opendoor’s contribution margin comes in at just 5%; at $20B in sales, it would generate $1B in contribution profits in 2022. Assuming 50% of contribution profits turn into free cash flow at maturity, Opendoor could make ~$500M in FCF. Therefore, we are paying just 6x EV/FCF for Opendoor. To be fair, I can’t find such lucrative pricing on any residential REITs (maybe there are some). Here are some of the ones I know:

YCharts

Now that I have shown Opendoor’s relative valuation compared to REITs, let us derive the absolute fair value and expected returns for Opendoor.

Opendoor’s Fair Value And Expected Returns

For 2022, I am expecting Opendoor to achieve $18-20B in sales with housing supply still at all-time lows and housing demand remaining robust despite a recent rise in mortgage rates to 5%+ (12-year highs). Although Opendoor’s margins could come under pressure if house prices decline sharply (they typically go down slowly if at all), I think these pressures would be temporary. In a bear market, Opendoor’s value proposition improves significantly for sellers, and Opendoor could realistically charge a higher service fee in a buyer’s market (bear market). With higher volumes, Opendoor should be able to maintain its gross profits even during downturns in housing.

As a market-maker, Opendoor’s transaction spread should stabilize in the 3-5% range in the long run. Additionally, Opendoor could generate another 5-10% margins from the sale of ancillary services (financing, insurance, moving, renovations, etc.). Hence, Opendoor’s free cash flow margins could reach a 6-10% level in the future. To implement a margin of safety, I will stick with a potential FCF margin of just 6%.

Assumptions:

Forward 12-month revenue [A]

$18 billion

Potential Free Cash Flow Margin [B]

6%

Average diluted shares outstanding [C]

~650 million

Free cash flow per share [ D = (A * B) / C ]

$1.66

Free cash flow per share growth rate

20%

Terminal growth rate

3%

Years of elevated growth

10

Total years to stimulate

100

Discount Rate (Our “Next Best Alternative”)

9.8%

Results:

L.A. Stevens Valuation Model

L.A. Stevens Valuation Model

According to my estimates, Opendoor is worth ~$73 per share (market cap: ~$50B), i.e., it is fundamentally mispriced. Furthermore, investors could generate a CAGR of 43% over the next ten years by buying Opendoor here at $8 per share.

Risks

  • While Opendoor has achieved a positive contribution margin for the last 20+ quarters (and is set to do so in Q1 2022, too), Opendoor’s AI/ML-based pricing models have not been tested in a bear market (buyers market). If Opendoor’s models fail to adapt in a bear market, the company could suffer significant losses.
  • Mortgage rates have gone up vertically over the last three months, going from all-time record low rates of ~2.5% to twelve-year highs of ~5.3%. As mortgage rates rise, house prices tend to normalize (and they could even decline). With the house price index at all-time highs, the noise of a housing bubble is growing louder. Furthermore, the Fed is about to start quantitative tightening and allow MBS run-off of ~$17.5B per month (for the next three months and then take it to $35B per month). Over the last two years, the Fed was a massive buyer of mortgage-backed securities, and not having monetary policy support could slow down demand for housing. With that said, mortgage rates and the Fed could do nothing to increase the housing supply, which is still much lower than demand.
  • During the housing bubble burst, average house prices in the US fell by about 25%; however, this fall materialized over four years. Opendoor’s average holding period is less than 120 days (and they claim to buy 5-15% below fair value), i.e., they are unlikely to lose money even during bear markets. I would prefer owning a market-maker over being a landlord if the real estate cycle were to turn.
  • If we assume that housing is in a bubble and it is going to burst over the coming 3-4 years, I think Opendoor’s margins will stay suppressed over this period. While many experts recommend buying REITs in high inflation periods with little regard to the real estate market cycle, I think owning Opendoor (market-maker) is a much safer bet. A normalization in house prices could lead to higher trading activity in the housing market, which is bullish for Opendoor. What Opendoor will lose in margins, it could make up in greater volumes.
  • Due to a tight labor market, Opendoor could face higher wages and labor costs. Also, a shortfall of labor could lead to slower asset turnover, which could affect sales growth and hurt the bottom line at the same time.
  • Rising interest rates could increase financing costs for Opendoor. As we know, Opendoor buys homes using floating-rate credit facilities, and while they hedge for interest rate risks, the hedges may prove to be inadequate if rates move too fast or too far. This may lead to higher interest costs and lower profitability.
  • Lastly, I would like to highlight a long-term risk. Opendoor is pioneering the iBuying industry; however, iBuying makes up less than 2% of the real estate market. While it is easy to say that iBuying will scale just like e-commerce, iBuying may hit a wall at some point in the next few years. Consumers know that an iBuyer will offer a price well below fair value for the added convenience, and buyers know that they will be asked to buy above fair value. The economic interests of iBuyers and their customers are not aligned, and that could hinder the rise of iBuying. We believe Opendoor is the only player in the market that has the scale to operate at razor-thin margins and still make the numbers (unit economics) work. With that being said, Opendoor may fail to appease the masses and change consumer sentiment around iBuying.

Concluding Thoughts

Inflation is supercharging Opendoor’s gross margins, which are expected to come in at ~10% in Q1 2022, and are currently tracking close to ~14% in Q2 2022. If inflation stays elevated, house prices will continue to go higher, and Opendoor will make more profits on its inventory. While I view Opendoor as a market-maker, its balance sheet may be viewed as a levered and diversified bet on the housing market. With net cash of ~$2.2B and housing inventory of $6B (acquired on debt), Opendoor has ample liquidity to support its operations. The company is very close to FCF breakeven, and it may achieve positive FCF in 2022 if the housing market stays strong (i.e., inflation remains at elevated levels).

I have said this before, but I must say it again –

The iBuying industry is still nascent (<2% market share), and the entire business model is being doubted after Zillow’s (ZG) blowup; however, Opendoor’s business performance and positive unit economics continue to show that Zillow’s problems were idiosyncratic to Zillow. Opendoor is outperforming financial expectations while building a 10x better consumer experience at a lower cost. In my mind, Opendoor is an unstoppable force.

While critics bash Opendoor’s razor-thin margins, we must realize that as a market-maker, Opendoor’s core buying and selling operations will have spreads of just ~5-10% (even in the long run). The real profits will come from ancillary services, and Opendoor is making incredible progress on these fronts. If you are interested in learning more about Opendoor’s new product offerings, please read my previous note on the business.

With changing macroeconomic conditions, some of you might be worried about Opendoor’s housing inventory of $6B (and a potential asset-liability mismatch); however, I think Opendoor’s cash position of ~$2.2B is ample cover for its business. During (and after) the housing/financial crisis, average home prices in the US tanked by ~25%, but this move took four years to materialize. Opendoor buys and offloads homes within ~120 days, and these purchases are made at ~5-15% below market value; hence, Opendoor will not be registering massive losses on their home sales even in a down market.

A negative home pricing environment could lead to temporary margin compression; however, Opendoor can purchase (and sell) more houses due to lower prices and make up for lower margins through higher volumes (and higher service fees).

The market hates iBuyers, and the consensus belief is that this business model will never work. However, Opendoor’s business performance and methodical platform expansion tell a different story altogether. Opendoor is doing what no other company has ever managed to do, and only a few may be able to replicate, if at all. My conviction in Opendoor’s vision and its management’s execution capabilities has never been greater, and hence, we view the sell-off in Opendoor as a generational buying opportunity.

As of Q4 2021, Opendoor has a total buying capacity of $30B (cash + credit facilities), which is roughly 5x of its current inventory. Hence, Opendoor has ample firepower to scale up in existing markets and enter new markets in 2022. With exciting products like Opendoor Complete and Opendoor Max coming to life, Opendoor’s platform is getting stronger and stronger. After Zillow’s exit, Opendoor has captured the lion’s share of the iBuying market, and considering the scale of this opportunity ($1.9T TAM), I think the investments (massive rise in SBC) being made by Opendoor’s management are fully justified. We may not see profits in 2022; however, if the Opendoor team can continue to execute as it has done over previous quarters, I think Opendoor can turn free cash flow positive this year.

With the premise of higher inflation for longer, most people will agree that owning real estate is a good idea. Being a landlord is not hassle-free, so REITs seem like an easy bet to make. While I think REITs are good investments during a period of high inflation, we must consider the prospect of a downturn in real estate. Opendoor, as a market-maker, is winning big time due to high inflation; however, it could do very well in a down market too (higher volumes, lower margins). Furthermore, at ~2.5x net cash, 6x EV/FCF (potential), and less than 0.2x P/S, Opendoor is priced for bankruptcy. Hence, I think Opendoor is the ultimate stock for the high-inflation environment we currently find ourselves in today.

Key takeaway: I rate Opendoor a table-pounding buy at $8 per share

Thank you for reading, and happy investing. Please feel free to share any questions, thoughts, or concerns in the comments section below.