A Note on eXp and Margins

Happy Friday, everybody. I’m deep in the heart of final edits on the June Red Dot report, tentatively titled “Zillow, Redfin, Realogy: The Shape of Things to Come” so haven’t been blogging as much. But in writing the June report, I looked at eXp in some detail as a comparable. In future reports, I may be able to go far deeper since eXp is now a full NASDAQ company.

And this morning, I see this profile of eXp and its founder and CEO, Glenn Sanford, on Inman News, written by Brad Inman himself, titled “Triumph of the nerd: how eXp Realty’s founder built a $1 billion business.” In it, I see this amazing section head: “Declining margins not an issue.”

I felt like I had to drop a brief post.

A few things: I know so many people at eXp and they’re all smart and wonderful people. Glenn and his lovely better half, Debbie, I’ve known for years. Glenn told me his idea about eXp years ago, and I remember sitting with him and his partner at a cafe in Washington DC before he launched it. My wife Sunny started in real estate with Debbie Biery lo these many years ago. They’re absolutely top notch human beings. Plus, I’ve known people like Mitch Robinson, Cynthia Nowak, and Scott Petronis for years.

Also, Sunny hangs her license with eXp and owns shares in it. So I have all kinds of reasons to love, root for, and support eXp.

Having said that… declining margins are not an issue? In what fantasy world? Maybe it’s because I’ve been writing the June Red Dot where margins are the issue that I feel compelled to say something.

Let’s get into it, shall we?

In Praise of eXp

Let’s start with the positives. As Brad writes, eXp has a market cap north of $1 billion. That’s no small feat, no matter what else one might think. And it is absolutely true that eXp’s growth has been meteoric: 6,000 in January to 12,000 in the space of four-ish months?

The virtual brokerage idea is… well… interesting, at the very least. Having been a lifelong PC gamer, and having spent the equivalent of years of my life in immersive 3D environments (from Asheron’s Call to World of Warcraft to, yes, Second Life), I get the concept of the virtual office with avatars.

I also absolutely understand that having no office space saves a ton of money, compared to traditional brokerages.

eXp’s stock-based compensation model for agents is also all kinds of interesting, as it takes KW’s profit-sharing to another level.

But… margins don’t matter?

There are Margins, and then there are Margins

Here’s what Brad wrote:

I asked Sanford about his declining margins, which he says is explained by his generous agent compensation program. Again, he beats the same drum, his mission is to build the eXp agent base, not worry too much about margins. Like all successful entrepreneurs, he is focused on the prize, knowing if he wins at that, he can fix other problems later.

But his financial story is different from tech brokerages like Compass who are sitting on a pile of venture capital. Sanford says that is not a problem, as the company is cash flow positive.

No doubt Glenn is focused on the prize, and since he’s worth $500 million and I’m worth far, far less than that, give the man credit for what he’s built.

However, I have to tap the brakes when he says eXp’s goal is to build the agent base, not worry about margins, and claim all is well since the company is cash flow positive.

Let us look at the actual numbers from the 10-Q filing:

Q1/2017Q1/2018
Net revenues 21,528,183 61,962,531187.8%
Cost of revenues 18,960,135 55,701,516193.8%
Gross profit/Company Dollar 2,568,048 6,261,015143.8%
  Gross margins11.9%10.1%-15.3%
General and administrative 2,109,352 15,688,748643.8%
Professional Fees 364,460 592,36562.5%
Sales & marketing 301,222 645,797114.4%
  Total expenses (incl. cost of rev)24,401,69872,628,426197.6%
Operating Income/(Loss) (2,873,515) (10,665,895)271.2%
Net Income/(Loss) (2,875,230) (10,665,895)271.0%
Agent count 3,100 9,290199.7%

Note that I computed the Gross profit/company dollar and the gross margins numbers, which is why they are in blue. Everything else is from the SEC filing.

The $10.7 million in Net Loss includes the following:

  • Depreciation: 183,321
  • Stock compensation expense: 8,279,109
  • Stock option expense: 1,301,702
  • Agent equity program: 2,370,004

The total from these four non-cash lines is $12,134,136. Then you add in accounts receivable, prepaid expenses, etc. etc. and you get to net Cash from Operations of positive $4.79 million. Positive cash flow, bam!

So far so good. We have seen this story before, time and again, when it comes to tech companies. Take Redfin as an example. It has posted loss after loss, year after year. There are no profit margins to speak of, since it has only posted losses — just like eXp. For that matter, Zillow has also posted eye-popping losses, leading the hoi polloi of real estate to pshaw at “venture backed losers burning investor cash.”

Thing is, there are margins and then there are margins. The Net Margin number doesn’t matter, since none of the companies have a net margin — losses means there’s really no such thing.

However, there is such a thing as gross margin. (To be precise, it would be cost of revenue margin, but more people understand gross margin.) That would be top line revenue, less the cost of revenue.

Cost of revenue is often included in general expenses, but I think they’re quite different from other expense lines, since the cost of revenue is literally what it cost to generate that revenue in the first place. A company has far less control over cost of revenue than it does on “normal” expenses, such as marketing spend or hiring another developer.

Compare these three Seattle-area public companies with a strong technology focus:

201520162017
 Zillow90.7%91.8%92.1%
 Redfin26.1%31.0%30.2%
 eXp14.9%13.3%10.6%

All three companies posted huge net losses, at least on paper. But look at the difference in gross (cost of revenue) margins. Zillow’s margins are going up, as it leverages its investment in technology and a mature customer base, to generate more dollars of revenue per dollar of cost of revenue. Redfin went up big, then moderated (as it is hiring employee agents by the bushel for strategic purposes).

Why is eXp’s gross margins (a) so thin, and (b) going down?

That decline does matter. Especially for a brokerage, tech-enabled or not. Why?

Cost of Revenue = Agent Splits

For most brokerages, including eXp, the single biggest expense line item is not office space. Nor is it payroll. It is cost of revenue, which is more or less equal to agent split.

In eXp’s case, we learn from the Inman article that eXp puts agents on a 80/20 split, with a $16,000 cap. That is more or less a traditional split-based brokerage model in the mold of Keller Williams.

There is a mountain of difficulty in improving that cost. In fact, I’m going to go out on a limb and suggest that it is near impossible for a split-based brokerage to improve its margins, when almost all of the cost is related to agent splits. We know this because Realogy has been trying for at least six years (since it went public again in 2012) to “moderate” agent commission pressure and failed.

Think of it this way. Redfin gets about 30 cents on the dollar for every dollar of GCI revenue it generates. But, its agents are W2 employees on a mix of salary + bonus (as far as I know from research), and as its agents do more business, Redfin’s revenues grow faster than its costs. So its gross margin improves.

eXp on the other hand works like any traditional brokerage: as its agents do more business, eXp’s revenues grow slower than its costs. In eXp’s case, it’s because of the cap; in the case of more traditional brokerages, it’s because top producers demand higher splits and/or a cap. So as eXp’s agents do more business, its cost of revenue increases, resulting in declining margins.

You don’t make that up in volume. Or growth.

Who Gets The Most Agents the Fastest Wins?

Brad says that Glenn’s mission is an agent grab, because he who gets the most agents the fastest wins.

Undoubtedly, that is the way real estate brokerage is structured today. It’s all about recruiting and retention, and butts in seats, and low cost is king.

And if Wall Street wants to reward the fastest and best agent recruiters, bully for them and bully for the companies and their shareholders who are rewarded (on paper).

I see things a little differently. Market share grab is fine, if you have the gross margins to support a narrative that after you’re done spending millions on technology, on advertising, on marketing, on brand building, etc., that you can leverage the investment in your infrastructure to start taking profits. Zillow is that story. So is Redfin, but with a far lower gross margin figure.

But if market share grab comes with a built-in tiny gross margin, which declines as your agents get more productive because of the way your cost of revenue is structured, I’m not sure what the point is. Where is the leverage?

Let me put the point differently. eXp has 12,000 agents and are growing fast. NRT has 50,000 agents and are growing very, very slowly. Both are cash flow positive. NRT has actual EBITDA profits, albeit tiny. Do you really think the NRT’s woes are because of office space?

In Parting…

As I’ve said, I have nothing but love for eXp, for Glenn and his team, and all of the shareholder agents — of which my wife is one. I hope they break $2 billion in market cap, and the stock goes to $100 a share. I really do.

There’s also no doubt that eXp has tapped into something going on in the industry, particularly at KW and Re/Max that Glenn says are his “hunting grounds.”

So this isn’t about eXp at all. Not really. It’s about the statement that margins don’t matter, as long as you’re growing agent count. I’m arguing the opposite. Margins matter greatly, no matter what your agent count, if we’re talking about gross margins.

92.1 vs. 30.2 vs. 10.4 — there’s a world of difference between those three numbers.

-rsh

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8 Comments

Join the discussion and state your opinion. Some comments may be held in moderation. I try to get to them as soon as possible, but may be traveling or unable to approve comments immediately. I do not censor comments, but reserve the right to remove anything that looks like spam, trolling, or just outright inappropriate.

  1. Would it be more fair to include Zillow’s SG&A expenses as a cost of sales? I realize they don’t state their army of sales people as a COGS because they I’m sure prefer to show a fat 90%+ margin to Wall Street, but for this comparison, it would seem to me their sales people compensation is analogous to an agent split. Little room to cut costs, no?

    1. I think that’s a question for Zillow management. I’m not sure where they put the salaries of their sales team. But note that their 2017 cost of revenue line was $85 million, excluding amortization and depreciation. That’s a lot of salaries.

      Or, it could be in the Sales & Marketing expense line. Hard to say.

      1. Rob, you don’t seem too enamored of eXp World Holdings. But why the continued comparison between Zillow and Redfin?

        As I noted here in my little treatise a couple weeks ago, http://simonsaysrealestate.com/2018/05/14/realogy-and-redfin-the-earnings-calls/, in Redfin’s 10-Q filing for its Q1 2018 earnings report, you see these words: “Redfin is a technology-powered residential real estate brokerage.”

        From Zillow’s latest 10-Q – “Zillow Group, Inc. operates the leading real estate and home-related information marketplaces on mobile and the web, with a complementary portfolio of brands and products to help consumers find vital information about homes and connect with local professionals. ”

        As I also noted in my write-up, I do agree with you – margins DO matter, regardless of what brokerage model a company represents. That’s why I compared Redfin to Realogy.

        But a comparison of Zillow to Redfin is like comparing Amazon to Staples. Yes they both have a noticeable online presence but just because they’re both in the same industry doesn’t make them direct competitors nor does it make sense to compare their financials.

        Just my opinion.

        Simon

      2. Hi Simon –

        First of all, love your blog! Since I was anonymous when I began Notorious, I appreciate that as well. Seriously great writing and great analysis, even if we don’t necessarily agree 100% on everything — that would be boring, after all. 🙂

        Second, I don’t compare Zillow to eXp or Redfin straight up. The reason for posting Zillow’s gross margin numbers is that I just wanted people in the industry to realize just how vast the gap is between tech and brokerage when it comes to cost of revenue margins. That also accounts for, I think, some of the different valuation treatments of these companies.

        But… I do think Zillow and Redfin are far more competitive than most people realize. That’s in my June Red Dot, but suffice to say that they’re tackling the same problem from different directions.

        Thanks for commenting! Hope you return soon, and I’m subscribing to Simon Says. 🙂

        -rsh

  2. In my opinion the root of the real challenge we have in the residential real estate brokerage business is the result of the chronic condition this industry has which I now call, “centricitis.” In brokerage you now need to fully disclose that you are agent-centric, Realtor-centric, broker-centric, franchise-centric, company-centric and so on. This with centricitis suffer from an issue with control. At the center of this control is the age-old fight for the control of the consumer. Those that are “someone else centric” will always suffer the financial burden of the price to pay for someone else’s control of what they consider to be “their consumer.” That control will determine the financial performance of any entity in this industry now and forever. “Cure centricitis”, and I believe that lots of other “illnesses” associated with be “cured” and this business will change fast.

  3. Rob, I appreciate you brother, and Glenn Sanford is right on the money. It’s about agent attraction for now. eXp is leading a shift in our industry toward technology, disintermediation, decentralization, local and distributed organizational design and a cloud-based footprint.

    By getting rid of intermediaries (franchisees and management fat), brick and mortar overhead and geographic impediments to expansion and growth, eXp created a platform that is a super highway for individual agents, mega teams and smaller brokerages seeking to leverage their businesses. What other brokerages offer truly meaningful rewards to their agents for sales production and agent attraction with revenue share and NASDAQ-traded stock?

    Jeff Bezos said, “Your margin is my opportunity.” Bezos sees a competitor’s love of margins and other financial ‘ratios’ as an opportunity for Amazon since the competitor will cling to them while he focuses on absolute dollar free cash flow and slices through them like a hot knife through butter. (Tren Griffin)

    Glenn and his leadership have been able to bootstrap eXp with virtually no debt or expensive venture capital. He’s in it for the long term and is putting a dent in the universe along the way. You might consider the power and opportunities for margin eXpansion that will arise when eXp becomes the largest broker in North America. Hey, GK, did someone say big data?

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