Opendoor is the Ultimate Stock for a High Inflation Environment (NASDAQ :OPEN).

Introduction

Over the past two years, central banks around the world have pumped tons of liquidity into their countries in response to the coronavirus pandemic. Inflation has been at an all-time high for many decades due to a combination of supply chain issues as well as loose monetary policy. Inflation is now at an all-time highInvestors in equity markets seem to have panicked after hitting multi-decade highs. Several growth stocks have fallen 50-90% since their highs and broader indexes are heading towards a correction.

Recent data from Q1 2022 GDP shows a -1.4% increase in y/y. This raises concerns about stagflation, which is characterized by low economic growth and high inflation. In stagflationary times, historically, real estate has outperformed bonds and stocks. As you can see, home price growth outperformed inflation despite rising interest rates (Volcker Regime).

Today’s US House Price Index stands at 358 with a record-breaking growth rate of 19.4%. This is due to record-low mortgage rates and wage inflation.

Most people agree that physical assets are the best way to go during high-inflationary times. It’s what has worked historically and it’s still working well in 2022. Retail investors are unable to afford investment homes and the hassle of being landlords is too much. In this environment, REITs are a good bet. Problem is that most market participants are familiar with this space so the potential for alpha is minimal. REITs could also be bad investments in the event of a downturn in the real-estate market.

In light of the idea that inflation will be higher for longer (as discussed by my economic outlook for 2022), I’d like to suggest a lesser-known option to participate in the realty bull market. Opendoor is my favorite stock for a high inflation environment.NASDAQ:OPEN). Why?

Opendoor is a market-maker in real estate. It’s likely that it will generate higher margins during periods when there is higher inflation (and positive appreciation in home prices). If inflation remains high, home prices will likely rise further, which will boost profitability and keep Opendoor’s gross profits elevated. Opendoor has maintained an open margin of positive contribution for more than 20 quarters. This means that Opendoor’s unit economics are positive.

Let’s see how Opendoor’s business compares to REITs at unit level.

1) A typical residential REIT would generate rental income of 6-12%. The assets of the REIT would appreciate by 5-10% annually in an inflation-prone environment. The total return would range from 10-22%.

2) Opendoor’s average holding time of less than 120 day means that it can turn its assets over three times per year. Opendoor could make between 21 and 45 percent gross profits if it assumed a gross margin of 7-15% for each transaction. Opendoor could still make between 20-25% contribution profits on capital after taking into account variable costs. Opendoor’s total return would be higher than a typical REIT.

Opendoor’s margins will likely shrink in a bear market. However, residential REITs will lose value if home prices drop. A real estate market-maker should perform better in a bear market than a REIT’s (asset owner/bagholder). Opendoor (market maker) is my preferred choice over REITs in all macroeconomic environment.

Inflation is a significant tailwind, and Datadoor estimates make it clear

Tyler Okland’s Datadoor.io estimates that Opendoor will record $5.2-5.4B in Q1 2022, which is roughly 20% more than management’s guidance. Gross margins of 9.7-10.5% are expected to be higher than consensus estimates (200 bps). Tyler’s Opendoor estimates were much closer to the actual results than management’s guidance or consensus analyst estimates in previous quarters.

Tyler and his team have done a fantastic job on Opendoor in the recent months. They are now compiling institutional-grade information for iBuying. It is now available at Datadoor.io.

You are welcome to take a look at it. These estimates are made possible by Tyler’s permission. Since the beginning of the year, I have been estimating 2022 revenue at $18B. It seems like my estimate will end up being too conservative. Opendoor’s Q1 report is exciting to me. I believe profitability guidance will be very important.

An alternative way to think about Opendoor

Opendoor’s business model has been criticized by some for the inherent risks associated with housing inventory being carried on its balance sheet. Opendoor’s balance-sheet structure makes it attractive in an inflationary environment. Opendoor has a net cash position of $2.2B and essentially owns 17K houses worth $6B. Opendoor’s inventory increases in value as house prices rise, and the debt becomes more expensive. Opendoor could therefore be seen as a leveraged investment in the housing market.

Opendoor is a market-maker. If you aren’t sure if it is right for you, consider it a single house. Opendoor trades at $5.2B, with $2.2B of net cash. Let’s suppose that Opendoor has a contribution margin of 5%. With $20B in sales it would generate $1B contribution profits in 2022. Opendoor could earn $500M in FCF if 50% of its contribution profits are converted to free cash flow at maturity. Opendoor is being charged 6x EV/FCF. To be fair, there is no residential REIT that offers such a lucrative pricing (maybe there are). Here are some I know:

Now that I’ve shown Opendoors relative valuation to REITs let us calculate the absolute fair value of Opendoor and expected returns.

Opendoor’s Fair Returns and Value

Opendoor will be able to generate $18-20B in 2022 sales, with housing supply at an all-time low and housing demand strong despite recent increases in mortgage rates to 5%+ (12 year highs). Opendoor’s margins might be affected by a sharp drop in house prices (they tend to fall slowly, if at all), but I believe these pressures will be temporary. Opendoor’s value proposition is significantly improved in a bear market. Opendoor could charge a higher service fee for buyers in a bear market. Opendoor should be able maintain its gross profits even in downturns in housing sales if it has higher volumes.

Opendoor should maintain its 3-5% transaction spread as a market-maker. Opendoor could also generate additional 5-10% margins through the sale of ancillary service (financing and insurance, moving, renovations, etc.). Opendoor’s free cashflow margins could rise to 6-10% in the future. To ensure safety, I will keep the FCF margin at 6%.

Assumptions:

Results:

Opendoor is fundamentally underpriced, according to my estimates. It is worth $73 a share (market cap: 50B). Opendoor can be purchased here for $8 per share and investors could see a 43% annualized return over the next ten-years.

There are risks

• Opendoor has had a positive contribution margin over the past 20+ quarters and is expected to continue this trend in Q1 2022. However, Opendoor’s AI/ML-based pricing model has not been tested in a bear or buyers market. The company could lose a lot if its models don’t adapt to a bear market.
• Over the past three months, mortgage rates have risen vertically. They went from record low rates (2.5%) to twelve-year highs (5.3%). House prices tend to normalize as mortgage rates rise. They could even drop. The noise of a housing bubble growing louder is evident with the house price index at an all-time high. The Fed is poised to increase quantitative tightening and allow MBS to run-off at $17.5B per months (for the next 3 months, and then increase it to $35B each month). The Fed has been a major buyer of mortgage-backed security over the past two decades. A lack of monetary support could lead to a decrease in housing demand. Despite this, mortgage rates and Fed could not increase housing supply as it is much lower than the demand.
• The average house price in the US dropped by 25% during the housing bubble burst. However, this drop was sustained over four years. Opendoor claims that their average holding period is less 120 days. They also claim to buy 5-15% below the fair value, so they are unlikely lose money even in bear markets. If the real estate cycle turned, I would prefer to own a market-maker rather than a landlord.
• If we assume that the housing bubble is bursting, then I think Opendoor’s margins would remain flat for the next 3-4 year. Experts recommend buying REITs in high-inflation periods, but I believe that owning Opendoor (market-maker), is a safer option. Opendoor could benefit from normalizing house prices, which could result in increased trading activity in housing markets. Opendoor could make up for what it loses in margins with greater volumes.
• Opendoor could be facing higher wages and labor costs due to a tight labor marketplace. A shortage of labor could also lead to slower asset turnover which could impact sales growth and negatively affect the bottom line.
• Opendoor may be more expensive to finance if interest rates rise. Opendoor purchases homes with floating-rate credit facilities. Although they hedge for interest rate risk, the hedges may not be sufficient if rates move too quickly or too far. This could lead to higher interest rates and lower profitability.
• Last but not least, I want to point out a long-term risk. Opendoor is a pioneer in the iBuying market. However, iBuying only makes up 2% of the real-estate market. It is easy to assume that iBuying can scale like ecommerce. However, iBuying may face a problem in the coming years. Consumers are aware that an iBuyer will sell products at a lower price than the market value, and buyers will be required to pay more than the fair value. The economic interests between iBuyers, their customers, and their competitors are not aligned. This could hamper the growth of iBuying. Opendoor is the only market player that we believe has the scale and ability to operate at very tight margins while still making the numbers (unit economics), work. Opendoor may not be able satisfy the masses or change consumer sentiment about iBuying.

Concluding Thoughts

Opendoor’s gross profit margins are being squeezed by inflation. They are currently at 14% in Q2 20,22, and expected to reach 10% in Q1 2020. If inflation remains high, house prices are expected to continue rising, and Opendoor will be able to make higher profits on its inventory. Opendoor is a market maker, but its balance sheet can be viewed as a leveraged, diversified bet on housing market. Opendoor has ample liquidity to sustain its operations with net cash of $2.2B, $6B housing inventory (acquired through debt), and net cash of $2.2B. Opendoor is close to FCF breakeven and may achieve positive FCF by 2022 if the housing sector remains strong (i.e. inflation remains at high levels).

This is something I’ve said before, but it’s important that I repeat it again.

The iBuying sector is still young (2% market share) and the whole business model is being questioned after Zillow’s (ZG). However Opendoor’s positive unit economics and business performance continue to prove that Zillow’s problems were idiosyncratic. Opendoor is exceeding financial expectations, while delivering a 10x better customer experience at lower costs. Opendoor is a force that cannot be stopped.

Opendoor’s razor-thin margins are criticized by some, but we must remember that Opendoor is a market maker and its core buying/selling operations will have spreads of only 5-10% (even long-term). Opendoor is making great progress on these fronts, and the real profits will come in the ancillary services. Opendoor’s new product offerings are available in my previous note.

Opendoor’s $6B housing inventory (and potential asset-liability mismatch) might be a concern. However, Opendoor’s cash position at $2.2B provides sufficient cover for its business. The average home price in the US fell by 25% during and after the financial/housing crisis. However, this move took four long years to happen. Opendoor purchases and offloads homes in less than 120 days. These purchases are made at 5-15% under market value. Opendoor therefore won’t be reporting large losses on home sales, even in a down market.

A negative environment for home prices could cause temporary margin compression. Opendoor, however, can purchase and sell more homes due to lower prices. It can also make up the difference through higher volumes (and higher fees).

The market hates iBuyers. There is a consensus belief that this model will fail. Opendoor’s business performance is a testament to its methodical platform growth. Opendoor is doing something no other company has achieved, and few others may be able duplicate it. Opendoor’s vision is unmatched, and the execution skills of its management are unparalleled. Therefore, we see the sale in Opendoor as a great opportunity to buy a new generation.

Opendoor has a total purchasing capacity of $30B (cash plus credit facilities) as of Q4 2021. This amounts to roughly 5x its current inventory. Opendoor has enough firepower to grow in existing markets as well as enter new markets in 2022. Opendoor’s platform continues to grow with the release of new products such as Opendoor Complete and Opendoor Max. Opendoor has seized the lion’s market share in iBuying. Given the size of the opportunity ($1.9T TAM), the investments made by Opendoor’s management (massive rise of SBC) are completely justified. While we may not make any profits in 2022 but if the Opendoor team continues to execute as it has over previous quarters, Opendoor could turn free cash flow negative this year.

Most people agree that real estate ownership is a good idea, given the fact that inflation will continue to rise. It is not easy to be a landlord, so REITs seem like a good investment. While REITs can be good investments during periods of high inflation, it is important to consider the possibility of a downturn. Opendoor, as a market maker, is enjoying a lot of success due to high inflation. However it could do very well even in a down market (higher volumes and lower margins). Opendoor is priced for bankruptcy at 2.5x net, 6x EV/FCF, and less than 0.2% P/S. Opendoor is, therefore, the ideal stock for the high inflation environment we find ourselves in today.

The Key Takeaway: Opendoor is a table-pounding investment at $8 per Share, according to my rating

Thank you for reading and happy investing. Feel free to ask questions, share your thoughts, or concern in the comments section.