Hold Off on Opendoor Technologies for These 3 Key Reasons

Opendoor Technologies Inc. (NASDAQ:OPEN) operates a digital platform for residential real estate in the United States, enabling consumers to buy and sell a home online. On Nov. 11, I highlighted what Zillow Group (NASDAQ:Z) backing out of the home-flipping business means for OPEN stock.

At the time, I expressed my concerns about the business model of Opendoor Technologies and its key risks. I concluded that “Opendoor needs to grab this opportunity and deliver positive financial results when Zillow quits leasing houses.”

OPEN stock closed that day at $22.56 and on Dec. 2, it closed at $14.55. That amounts to losses of about 35% in less than one month. Let’s talk about why this selloff occurred and what investors should do now with OPEN stock.

Was Q3 a Good Quarter for Opendoor?

Shortly after the company’s third-quarter 2021 earnings were released, Opendoor CFO Carrie Wheeler talked to Yahoo! Finance about the results. Wheeler stated:

“We had a great quarter. As you said, we beat expectations top line and bottom line. Really proof positive that consumers are increasingly demanding the solution we’re providing. We had conversion at 35%, record demand for our product, record revenue, and marked our 29th consecutive quarter a positive contribution margin. Just really good results all the way around.”

But the stock market apparently had another opinion. How do you explain a great quarter when OPEN stock tumbled by 35% in less than one month? Part of the answer lies in Wheeler’s later statement from the interview:

“…This is not a side business for us. This is our business. We’ve had seven years of investment in building robust pricing systems, acquiring the data, the modeling, the team to do that with a great level of accuracy. And we’ve been building the low cost platform over time that allows us to be able to let people buy and sell their home with ease and that a better cost and a more efficient way.”

Based on this and the Q3 results, I believe Opendoor’s business model now has at least two severe flaws.

The Fundamentals of OPEN Stock

Some of the notable Q3 2021 highlights for Opendoor Technologies were:

• Revenue rose by 91% compared to Q2 2021 to $2.3 billion.
• A total of 5,988 homes were sold through Opendoor, up 72% compared to the previous quarter.
• GAAP gross profit reached $202 million compared to $159 million in Q2 2021.
• Opendoor’s GAAP gross margin was 8.9%, versus 13.4% in the prior quarter.
• The company saw a contribution profit of $170 million compared to $128 million in Q2 and a contribution margin of 7.5% versus 10.8% in Q2.

Opendoor Technologies has been an unprofitable company for the past two consecutive years, and the key metric of GAAP net income reported in Q3 2021 was negative. Net income was a loss of $57 million versus a loss of $144 million in the second quarter.

In its Q3 earnings release, Opendoor Technologies mentioned it expects a Q4 contribution margin in the mid-single-digit range. The company is optimistic that it will be kept between 4% to 6% on an annual basis. And for the long-term, this contribution margin may be in the range of 7% to 9%.

But why is the contribution margin so important? It is a measure of profitability. The contribution margin ratio is a company’s net revenue minus its variable costs, then divided by the total revenue.

As a percentage of sales, the lower the contribution margin ratio is, the lower the profitability. In Q3 2021, the contribution ratio declined as a percentage, not as an absolute number.

With expectations of a lower contribution margin by the management of Opendoor, it is very likely that in absolute numbers, this ratio should decline. This is not good news for its profitability, which in terms of net income is already negative.

Opendoor Needs to Sell Its Large Inventory

Opendoor Technologies reported in its Q3 2021 earnings release that its inventory balance grew to 17,164 homes. That’s a $6.3 billion value, up 130% compared to Q2.

Redfin Corporation (NASDAQ:RDFN) chief economist Daryl Fairweather made a great argument as to why this is so risky. He stated, “…we’re in for a slowdown later next year, especially as mortgage rates start to rise.”

Fairweather did not predict that house prices will collapse. But having a large inventory of houses to sell when mortgage rates are going to rise as a result of Federal Reserve tapering is not a good idea.

Having a large inventory of any product is too risky, whether it is homes or consumer goods. What would be best is the exact opposite: having a minimal level of inventory. Why? Businesses generate revenue by selling products, not by keeping them.

Opendoor Technologies has made a very risky bet by increasing its inventory of homes substantially during the past quarter. Investors have realized the risk is too high considering an imminent slowdown in the housing market due to rising mortgage rates.

The Bottom Line on OPEN Stock

According to Simply Wall Street, shareholders of Opendoor have been considerably diluted in the past year. Total shares outstanding grew by 1,059.2%. This is a massive stock dilution, hurting the intrinsic value of OPEN stock.

Considering this plus the two aforementioned factors — a subpar quarter and a catalyst of rising interest rates — OPEN stock is now a risky bet on the future of the housing market. My previous suggestion for investors to wait until Opendoor Technologies reports profitability remains intact.

On the date of publication, Stavros Georgiadis, CFA  did not have (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.

Stavros Georgiadis is a CFA charter holder, an Equity Research Analyst, and an Economist. He focuses on U.S. stocks and has his own stock market blog at thestockmarketontheinternet.com/. He has written in the past various articles for other publications and can be reached on Twitter and on LinkedIn.