Zillow’s Earnings Set Up a Triple Digit Opportunity for Investors
Trade summary: A bull call spread in Zillow Group, Inc. (Nasdaq: ZG) using the November $120 call option which can be bought for about $4.90 and the November $125 call could be sold for about $2.85. This trade would cost $2.05 to open, or $205 since each contract covers 100 shares of stock.
In this trade, the maximum loss would be equal to the amount spent to open the trade, or $205. The maximum gain is $295 per contract. That is a potential gain of about 143% based on the amount risked in the trade.
Now, let’s look at the details.
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“Zillow shares are trading sharply higher in response to third- quarter earnings that got a boost from a robust residential real-estate market, though one dramatically remade by the pandemic.
For the quarter, ZG reported revenue of $657 million, down 12% from a year ago, but well above the range of $543 million to $581 million it had predicted.
The company saw 24% growth in its core internet, media, and technology (IMT) segment, lifting revenue to $415 million, ahead of its guidance of $369 million to $384 million.
The Homes segment, which includes direct purchases and sales of single-family homes, had revenue of $187 million, down 51%, but ahead of its forecast of $140 million to $160 million. Mortgage segment revenue was $54 million, up 114% and ahead of the guidance range of $34 million to $37 million.
Zillow reported adjusted earnings before interest, taxes, depreciation and amortization of $152 million, well ahead of the $59 million to $82 million in Ebitda it had told investors to expect.
For the December quarter, Zillow expects overall revenue of $709 million to $748 million, including $400 million to $415 million from the IMT segment; $260 million to $280 million for the Homes segment; and $49 million to $53 million for mortgages. Zillow sees adjusted Ebitda for the quarter of $107 million to $131 million.
“As this year has progressed, two tailwinds to our business have emerged – one in residential real estate and one in the adoption of technology,” the company said in a letter to shareholders.
“An increased desire and growing ability to move, as people rethink their relationship with home and work, is causing a Great Reshuffling across the U.S. … We believe these tailwinds are durable, supported by low interest rates and demographic shifts, as Millennials age into their prime home buying years with Gen Zs lining up behind them.”
Zillow noted that in its Homes business, the company resumed buying properties late in the second quarter and early in the third quarter, and increased the rate of purchases as the company became more comfortable both with data about the market and an ability to operate safely during the pandemic. In the quarter, the company bought 808 homes, and sold 583. Zillow said it ended the quarter with 665 homes in inventory, up from 440 at the end of the second quarter.
RBC Capital analyst Mark Mahaney raised his rating on Zillow shares to Outperform from Sector Perform, with a new price target of $147, up from $74.
”We fully acknowledge we missed the strong – 126% – run-up in the stock year to date” through Thursday, Mahaney wrote. “But we have come to better appreciate the behavioral (reshuffling) and technology (remote access) changes wrought by the Covid crisis and other factors.”
Mahaney said Zillow has been accelerating growth in its Prime Agent program, which he says “should be relatively sustainable given .. [the] forced reallocation of marketing dollars given the physical mobility restrictions on traditional forms of media.” And he thinks that the Homes business should reach positive unit economics reasonably soon.
While Zillow’s “valuation has gone through a material re- rating… there is room for material upside given our view of the sustainability of recent trends,” he said.
This move in ZG pushes the stock above resistance and could be the beginning of a strong trend.
A Specific Trade for ZG
For ZG, the November options allow a trader to gain exposure to the stock. This trade will be open for about three weeks and allows for traders to turn over capital quickly, potentially compounding gains several times a year.
A November $120 call option can be bought for about $4.90 and the November $125 call could be sold for about $2.85. This trade would cost $2.05 to open, or $205 since each contract covers 100 shares of stock.
The amount paid to enter the trade is the largest possible loss on the trade. This is generally true whenever a trader is creating a debit to enter an options trade. “Creating a debit” means there is a cost to enter the trade. You could create a debit by simply buying puts or calls to open a directional trade.
In this trade, the maximum loss would be equal to the amount spent to open the trade, or $2.05.
The maximum gain on the trade is equal to the difference in exercise prices less the amount of the premium paid to open the trade.
For this trade in ZG, the maximum gain is $295 ($125- $120= $5; 5- $2.05 = $2.95). This represents $295 per contract since each contract covers 100 shares.
Most brokers will require minimum trading capital equal to the risk on the trade, or $205 to open this trade.
That is a potential gain of about 143% based on the amount risked in the trade. The trade could be closed early if the maximum gain is realized before the options expire.
A Trade for Short Term Bulls
As with the ownership of any stock, buying ZG could require a significant amount of capital and exposes the investor to standard risks of owning a stock.
To reduce the risks of a trade, an investor could purchase a call option. This allows them to benefit from upside moves in the stock while limiting risk to the amount paid for the options. However, buying a call option can also require a significant amount of capital and includes the risk of a 100% loss.
Whenever an option is bought, the maximum risk is always equal to 100% of the amount of spent to purchase the option. Since options cost significantly less than a stock, the risk in dollar terms will be relatively small to own an option.
To further limit the risks of the trade, an investor could use a bull call spread. This strategy consists of buying one call option and selling another at a higher strike price to help pay for the cost of buying the first call. The spread strategy always reduces the risk of an options trade.
This strategy is designed to profit from a gain in the underlying stock’s price but the benefit of avoiding the large up-front capital outlay and downside risk of outright stock ownership. The potential risks and rewards of this strategy are summarized in the chart below.
Source: The Options Industry Council
Both the potential profit and loss for the bull call spread are limited. The maximum loss is equal to the net premium paid when the trade is opened. The maximum profit is limited to the difference between the strike prices, less the debit paid to put on the position.
This strategy could be especially appealing with high priced stocks where the share price and options premiums are often a significant commitment of capital for smaller investors.