In June 2022, the Consumer Price Index (CPI), a measure of inflation, recorded an annual rate of 9.1%, the highest level in the past 40 years and well above the Federal Reserve's target of 2%. To contain this, the Fed aggressively raised the federal funds rate from a record low of 0.25% to 5.50%.
The housing market has been a big victim of this policy shift. Higher interest rates reduce the average homebuyer's ability to borrow and often lead to fewer sales. Indeed, U.S. existing home sales in May were at an annualized rate of 4.1 million, 38% below the 2021 peak of 6.6 million, when interest rates were at record lows.
Real estate technology company Redfin (NASDAQ: RDFN) operates one of the largest real estate brokerages in the U.S., covering 98% of the U.S. market. As expected, rising interest rates and slowing home sales have caused the company's business to plummet, and its stock price has fallen 93% from its all-time high.
However, Wall Street is expecting the Fed to cut rates twice by the end of 2024, which could be just the catalyst Redfin shares need to recover. Here's why now might be an ideal time to buy the stock.
Image source: Getty Images.
Redfin adjusted its business to weather the real estate winter
Redfin's business used to have two distinct parts: direct buying, or iBuying, where the company would purchase homes from sellers and then resell them at a profit, and real estate services, which also included its brokerage division. In 2022, iBuying accounted for more than half of Redfin's total revenue, but the company decided to shut down the division that year as rising interest rates threatened to upend the housing market.
The iBuying business had very thin margins, so any decline in the value of Redfin's real estate inventory could send losses soaring. Now, the company is focusing on services areas like brokerage, rental marketplace, title services, and mortgage lending, which have much higher gross margins and help improve Redfin's bottom line (more on this later).
In the first quarter of 2024 (ending March 31), Redfin's 1,658 lead agents helped the company account for 0.77% of home sales nationwide. Redfin charges just a 1.5% listing fee, well below the industry standard of 3%. If the seller also agrees to use Redfin to buy their next home, the commission drops to 1%. As a result, more than a third of transactions in the first quarter were with repeat buyers.
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Additionally, a record 30% of customers who bought a home through Redfin in March also used the company's mortgage services, helping the company increase the revenue it earns from each transaction.
Revenue growth has stagnated, but profitability is in sight
Redfin generated revenue of $225.5 million in the first quarter of 2024, up 5% from the same period a year ago. That sounds like a modest increase, but considering the sharp decline in existing home sales we mentioned earlier, any growth is a win.
During these tough times, Redfin is focusing on cutting costs to stay afloat until conditions improve, including a new compensation plan for some agents who are willing to forgo salary in exchange for higher commissions.
Redfin's preferred profitability measure, adjusted EBITDA (non-GAAP earnings before interest, taxes, depreciation and amortization), was still negative $27.6 million in the first quarter, but that was an improvement from a negative $63.6 million in the same period last year.
Management said Redfin was on track to achieve positive EBITDA of $2 million in the second quarter, which ended June 30, and expects to be profitable for the full year. Hitting that profitability milestone will be crucial, since the company has just $107 million in cash on its balance sheet. That said, the company has another $165 million in loans on its balance sheet that it plans to sell to turn into cash.
Redfin refinanced some of its debt late last year, extending repayment maturities through 2027, reducing its risk of running into cash difficulties.
Redfin shares are trading at rock bottom
Following the stock price crash, Redfin's market capitalization is now just $720 million. Wall Street expects the company to bring in more than $1 billion in revenue this year, but its price-to-sales multiple (P/S) is just 0.7.
In other words, the housing market is so weak right now that investors are valuing Redfin for less than one year's worth of earnings. For comparison, just three years ago, investors were valuing the company for more than nine times its annual earnings.
RDFN PS Ratio Chart
Redfin's valuation looks unfair by comparison to one of its real estate technology peers, Zillow Group, which is currently trading at 5.5 times earnings despite shrinking its business and barely growing recently.
The CPI fell to a much more manageable 3.3% annualized rate in May. While that's still above the Fed's 2% target, many Wall Street analysts believe the downward trend is clear enough for the central bank to start cutting rates. CME Group's FedWatch tool projects one 25-basis-point rate cut in September and another in December. If inflation continues to fall, rate cuts could gain momentum in 2025.
I think it's very hard to make a case for a minimum valuation for Redfin at this point. As soon as interest rates start to fall, the real estate industry should see a wave of homebuyer activity, which will almost certainly boost Redfin's business. Investors willing to buy Redfin shares ahead of that change could be positioned for long-term gains.
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Anthony Di Pizio has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Redfin and Zillow Group. The Motley Fool recommends CME Group and recommends Redfin's August 2024 $11 call options. The Motley Fool has a disclosure policy.
The post 1 Super Stock to Buy Before the Fed Cuts Interest Rates was originally published by The Motley Fool