Drawing Capital Newsletter
October 15, 2020
[Diagram from Opendoor’s Investor Presentation (2)]
For a bonus edition, this week will feature two newsletters from Drawing Capital. Today’s topic will focus on understanding Opendoor’s key trends and business model. Tomorrow’s topic will feature the multiple methods of a private company seeking a public listing on a stock exchange, including an IPO, SPAC, or direct listing.
For a friendly reminder, this newsletter should not be taken as investment advice, nor is it a recommendation to buy or sell Social Capital Hedosophia Holdings Corp II shares (ticker symbol $IPOB) or Opendoor shares.
In a recent CNBC interview with Opendoor CEO Eric Wu and Social Capital CEO Chamath Palihapitiya, Opendoor announced its intention to become an independent, publicly-traded company via SPAC transaction with Social Capital Hedosophia Holdings Corp II (ticker symbol $IPOB) (3). A SPAC is a special purpose acquisition company, also known as a “blank check” company. This announcement demystified Opendoor’s business model, future growth prospects, and vision in disrupting the traditional residential real estate home selling market through a technology-driven digital experience that focuses on speed, certainty, and convenience. Opendoor’s core business model is quickly making cash offers to property sellers and then reselling the home at a higher price, often after making home renovations.
During this CNBC interview, Mr. Palihapitiya eloquently described the current state of the consumer real estate industry in America:
68% of Americans are homeowners
5 million homes are sold every year in the US
Consumer real estate is the largest, undisrupted market in the US, worth about $1.6 trillion annually
Consumer real estate market suffers from high fragmentation, inconvenience, and low Net Promoter Score (“NPS”)
28% of consumer-focused realtors are part-time.
In addition, Mr. Palihapitiya presented a number of industry tailwinds that currently exist in the consumer real estate industry:
There exists constrained supply due to lack of resale inventory and tepid growth in new home building.
COVID-19, “work from anywhere movement”, and changes in tax policy have sparked discussions among millions of American households regarding making a decision to relocate.
75 million millennials are entering the housing market and often desire high quality digital experiences.
Federal Reserve’s current interest rate policy, future interest rate posturing, quantitative easing programs, and additional monetary stimulus measures will target and influence a near-zero interest rate policy for years.
Under the ongoing COVID-19 landscape, consumers are increasingly choosing digital experiences and relocating to less urban areas. De-urbanization and relocation lead to more buying and selling of homes, and a low interest rate environment supports the housing market via low borrowing costs.
Enter Opendoor, which desires to make the process of selling a home simple, instant, more online, and more convenient. Opendoor was founded in 2014 and was named in CNBC’s “Disruptor 50 List”. Opendoor seeks to utilize this new access to capital on its balance sheet after the completion of the SPAC transaction to fuel the goals of increasing market share, expanding into new markets, and investing into new and existing products. By focusing on these three growth goals, Opendoor seeks to achieve the following virtuous cycle in its business model:
In the following chart below, it is clear that Opendoor is already providing better consumer experiences, high satisfaction amongst consumers, and a substantially better net promoter score (“NPS”) compared to the existing incumbents. As a corollary, the NPS chart comparison for Netflix, Uber, and Carvana against their industry incumbents highlight the power of consumer satisfaction through a digitally-distributed, technology-enabled business model that focuses on the recurring theme of speed, certainty, and convenience.
[Source: Opendoor’s Investor Presentation (2)]
From a financial perspective, Opendoor essentially is a liquidity provider in residential real estate. In US equity markets, market making and liquidity providers (such as Citadel Securities or Virtu Financial) are profitable and repeatable business when conducted with high market share. Liquidity providers accept risk by purchasing an asset in the open market (thereby providing immediate liquidity to the asset owner), inventory the asset’s risk, and then recycle the risk back into the market when a willing buyer emerges.
Opendoor’s current business plan is to focus on dynamic cities that are not in the highest-cost locales in order to drive deal volume, expand into more markets with less capital, reduce asymmetric risk-taking associated with ultra-luxury homes, and further refine its data models. Currently, Opendoor is 4.4x larger than the next closest competitor, and Opendoor has about a 4% market share in its existing core cities where it operates. Additionally, being a technology-enabled, low-cost provider that consistently provides value to consumers allows companies to gain market share, even during economic recessions.
Interestingly, there exists a significant liquidity premium (or illiquidity discount) for home sellers due to the arduous nature of selling a home. As a result, an increasing number of home sellers are willing to pay for speed, certainty, and convenience. This payment for these key traits is via a single digit percentage discount off of the fair market value of the seller’s property. There is an inverse relationship between fees and home seller conversion on the Opendoor platform. As the single digit percentage fee decreases, conversion rates for Opendoor in consumers willing to sell their homes through Opendoor increases. Intuitively, this is rational: more home sellers are willing to use Opendoor to sell their home when they receive a higher price on their home and pay less fees.
An illiquidity discount negatively impacts the value of illiquid assets due to higher transaction costs and higher discount rates. Higher discount rates are associated with lower valuations via traditional valuation techniques. When buying or selling assets, there are four types of transaction costs:
opportunity cost associated with waiting to trade
price impact associated with a transaction
These four types of transaction costs also apply to the residential real estate market. Opendoor provides liquidity into the residential real estate market. Enhanced liquidity in the residential real estate market reduces discount rates and transaction costs. As a result, enhanced liquidity benefits homesellers and homebuyers via lower transaction costs, benefits homeowners via higher home prices, benefits governments due to greater revenue from capital gains taxes and property taxes, and reduces the qualitative friction and stress associated with relocating.
Finally, an intriguing question remains: can Opendoor remove friction and costs to the consumer for property selling and purchasing with future flywheel business effects in the same way that Charles Schwab did for stock trading (ie. lowering stock trading costs since “May Day” in 1975, followed by establishing flywheel business segments in index funds, mutual fund superstores, fixed income investing, asset management, wealth management & financial planning services, banking, robo-advisors, and personal trust services)?
Financial Highlights Upon the Announcement of the SPAC Transaction with $IPOB
Opendoor’s 2019 revenue is $4.7B, and its estimated revenue in 2023 is $9.8B.
The SPAC transaction values Opendoor at a $4.8B enterprise value and a $6.3B equity market cap, which equates to about a 1x EV/2019 revenue multiple or a 0.5x EV/2023 revenue multiple. These are very modest enterprise value (EV) multiples that provide some degree of a margin of safety, particularly when compared against the EV/revenue multiples of many software companies and technology businesses.
If Opendoor can execute on its core mission and business model and reach a 4% market share nationwide, that could create a company with $50B in revenue. If Opendoor is valued at a 1x revenue multiple (Opendoor is currently valued at a 1x 2019 revenue multiple), then this would create a $50B enterprise value for Opendoor, which represents a 10x increase in enterprise value from its current SPAC deal value.
Key Metrics for Growth and Monetization
A common criticism of Opendoor is that a property seller paying an implicit fee of 5-10% is still on par with or more expensive than the traditional realtor model. This criticism is intellectually incorrect on an apples-to-apples basis for the following reasons:
In addition to a realtor’s typical 4-6% commission that is split between the seller’s agent, the selling agent’s firm, the buyer’s agent, and the buyer agent’s firm, a home seller also needs to be aware of closing costs, costs associated with concessions and home repairs, extra cash outflow associated with carrying a double mortgage, moving costs, staging costs, home warranties, etc. In total, these costs can total 10%+ of a property’s value to a home seller.
Realtors often take significantly longer to sell a home compared to a property seller receiving an Opendoor offer within 1-3 days. Extended timelines can create higher opportunity costs, including fall-through risks associated with buyers backing out of contracts, double mortgages, an illiquidity discount on the home’s market price, buying new homes on contingencies based on the sale of a previous home, higher carrying costs associated with accrued property taxes, and ongoing general maintenance costs.
Opendoor does not require staging a property that is being sold, which saves money for home sellers.
A second common criticism of Opendoor is that Opendoor is simply a glorified home-flipper that may face deep financial trouble in the event of a collapse in the housing market. While this criticism is valid, the following reasons can counterbalance this criticism:
Opendoor has demonstrated resiliency during the COVID-19 pandemic and during the worst economic recession in America since the Great Depression.
While a major correction in the housing market can be detrimental to Opendoor’s financials and growth prospects, there exists significant tailwinds to support the housing market in the short term.
Opendoor’s net housing exposure is based on its inventory levels, which are typically held for a short duration.
Residential home-flippers typically buy properties at market prices in hopes of reselling properties at higher prices and clearing an accounting profit after transaction costs, borrowing costs, and taxes. By acting as a liquidity provider as opposed to a home-flipper, Opendoor is buying homes at a discount to perceived market values. Therefore, Opendoor can theoretically earn revenue and positive contribution margin across a multitude of market environments (similar to how sophisticated market markers can earn revenue in all market environments for US equities, futures, options contracts, etc.).
Key Risk Factors
Zillow, Redfin, and iBuyer platforms may create competition and pricing pressure for Opendoor.
Individuals seeking a more personalized approach with a high caliber realtor may have a better experience compared to the Opendoor experience.
High quality realtors and realtors in high-cost locales in the traditional brokerage model can continue to perform well with little competition from Opendoor.
Opendoor must continuously improve and adapt its pricing model due to the high cardinality of homes across various locations, sizes, architectures, etc.
Opendoor has a history of net income losses and will need to continue expanding its business and improve efficiency in hopes of reaching future profitability.
Opendoor holds inventory risk of homes in a short duration time period. Opendoor’s business model implies that it benefits from re-selling homes at higher prices while maintaining low inventory levels.
Opendoor’s growth is partially dependent on its strategic relationships with third parties and the MLS providers in key markets.
Lack of quality execution on the virtuous cycle may impair Opendoor’s ability to recognize the true value of the optionality associated with operating related business segments in concert with its core business. This theory, combined with possible slower growth rates, may reduce the company’s value.
Possible Growth Trajectories
Increase Opendoor home sales, especially since home sales increase revenue, margins, and technology efficiencies inside Opendoor’s proprietary technology and data platforms.
Increase market share in existing markets.
Expand Opendoor into 100 markets in America.
Enter into and expand business in the high-end luxury residential market.
Expand services and product offerings to consumers, such as title insurance, home repair, moving services, partnerships with mortgage underwriters, and other business segments that are related to Opendoor’s core mission.
Ownership Structure & Team
Opendoor is a founder-led company. Eric Wu is both the CEO and Co-Founder of Opendoor.
Several Opendoor executives have prior experience at leading technology companies including Amazon, Google, Netflix, Square, Airbnb, Uber, Lyft, Twitter, and Expedia. All of these companies share the same traits of adopting a technology-driven approach to bring speed, certainty, and convenience to their respective businesses. Now, this team is bringing these traits to real estate with Opendoor.
Opendoor has partnered with a SPAC (Social Capital Hedosophia Holdings Corp II under ticker symbol: IPOB) and Chamath Palihapitiya in order to become an independent publicly-traded company. In a recent CNBC interview, Opendoor CEO Eric Wu cited that the reasons for Opendoor going public via a SPAC were primarily driven by the speed to market and the ability to partner with Mr. Palihapitiya’s value-added expertise as a premier technology investor and business operator. In addition, Mr. Palihapitiya has turbo-charged the recent “SPAC trend” and has previously experienced a successful SPAC transaction via a deal between Virgin Galactic Holdings and Social Capital Hedosophia Holdings Corp I (previously under ticker symbol IPOA), which now trades under ticker symbol: SPCE.
Reviewing Mr. Palihapitiya’s recent five SPAC transactions in ticker symbols $IPOA, $IPOB, $IPOC, $TRNE, and $FVAC, one can deduce a list of implied parameters that Mr. Palihapitiya seeks when evaluating SPAC transactions:
Find large markets with a significant incumbent-dominated market. Often, these incumbent-dominated markets have mediocre or low customer satisfaction scores and inadequate technological progress. Examples of these types of markets include healthcare, education, space travel & tourism, residential real estate, decarbonization, financial services, manufacturing, and other industries.
Look at companies with reasonable valuations: forward projected EV/revenue multiples and other valuation metrics should be modest, especially when compared to other high-flying software and cloud computing companies.
Look for a virtuous cycle with potential future flywheel effects.
Look to leverage technology and operating expertise to scale businesses.
Look for disruptive technologies that enable durable moats in businesses. These types of technologies enhance consumer experiences, can decrease costs, can increase speed of delivery to consumers and enterprises, and questions an incumbent company’s business model.
Look for a margin of safety based on both modest valuation multiples and strong underlying industry tailwinds.
Focus on companies and technologies that have the asymmetric potential to provide transformative experiences, advance humanity forward, and solve hard problems.
Democratize investor access and improve liquidity by allowing public market investors to finance and invest in the long-term growth of iconic technology companies.
Avoid companies that have large customer acquisition costs on Google and Facebook.
Avoid companies that do not have strong projected future revenue growth rates.
Build a portfolio of companies with the possibility of generating a 10X return in 10 years.
Invest a minimum of $100M of his own personal money into each of his SPAC transactions as an additional alignment of interests.
In conclusion, Opendoor presents an interesting opportunity to re-shape the traditional home selling process with a digital experience that focuses on speed, certainty, and convenience. As Opendoor’s home selling volume rebounds and grows over time, the company’s positive adjusted gross margins and contribution margins can allow the company to scale upwards with increased capital. While notable risk factors exist, Opendoor offers a compelling mission statement and presents a unique risk-reward dynamic in providing an innovative technology-enabled workflow for buying and selling homes. At Drawing Capital, we remain enthusiastic and optimistic about Opendoor’s future business trajectory.
(1) "SEC Form S-4 Social Capital Hedosophia Holdings Corp. II - tm2030455-1_s41 - none - 98.6912896s - SEC.gov." https://www.sec.gov/Archives/edgar/data/1801169/000110465920112009/tm2030455-1_s41.htm. Accessed 11 Oct. 2020.
(2) "Investor Presentation - Opendoor." https://www.opendoor.com/w/wp-content/uploads/2020/09/Opendoor-overview-investor-presentation.pdf. Accessed 11 Oct. 2020.
(3) "Palihapitiya in $4.8 billion SPAC deal for real estate start-up ...." 15 Sep. 2020, https://www.cnbc.com/2020/09/15/palihapitiya-finds-next-10x-idea-with-4point8-billion-spac-deal-for-real-estate-start-up-opendoor.html. Accessed 11 Oct. 2020.
(4) "Opendoor CEO Eric Wu on deal with Chamath ... - YouTube." 15 Sep. 2020, https://www.youtube.com/watch?v=sBD9bBjgEeo. Accessed 11 Oct. 2020.
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This letter is for informational and educational purposes. This letter is not an offer to sell securities of any investment fund or a solicitation of offers to buy any such securities. An investment in any strategy, including the strategy described herein, involves a high degree of risk. Past performance of these strategies is not necessarily indicative of future results. There is the possibility of loss and all investment involves risk including the loss of principal.
The information in this letter was prepared by Drawing Capital and is believed by Drawing Capital to be reliable and has been obtained from sources believed to be reliable. Drawing Capital makes no representation as to the accuracy or completeness of such information. Opinions, estimates and projections in this letter constitute the current judgment of Drawing Capital and are subject to change without notice. Drawing Capital currently owns shares in Social Capital Hedosophia Holdings Corp II (ticker symbol: IPOB).
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