This Is Opendoor's Biggest Risk (Hint: It's Not the Housing Market)

Key Points

• Opendoor's cost of sales account for around 92% of its top line.

• Other companies gave up on the iBuying business because it was too difficult to predict prices and turn a profit.

• Revenue growth alone may not be a recipe for Opendoor's stock to succeed in the long run.

• 10 stocks we like better than Opendoor Technologies ›

Opendoor Technologies (NASDAQ: OPEN) is in the business of iBuying, which involves buying and selling houses. If the housing market is in good shape, then that can result in a lot of business for the company. While there are still challenges in the economy, interest rates are coming down, which could lead to more favorable conditions for Opendoor to grow its business.

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But there are factors that are more important for Opendoor investors to consider than just whether the housing market will be strong or not. The company could after all, still do poorly, even if home sales are rising. And that's because the biggest risk with Opendoor pertains to its low gross margins.

Image source: Getty Images.

Opendoor needs better margins

A company's gross margin tells investors how much of revenue is left over after factoring in cost of sales. For Opendoor, its margins are the difference between what it sells a house for versus what it paid for it, plus any other expenses it incurred while selling it, including possible repairs and renovations.

The company's gross profit in its most recent quarter, which ended on June 30, totaled $128 million, which was less than the $129 gross profit it reported in the prior-year period. That was despite its top line rising by nearly 4%, to nearly $1.6 billion.

As a percentage, its gross profit this past quarter was just 8.2% of revenue. This is before even taking into account its overhead and other indirect expenses. And even though its operating expenses declined by 30% last quarter to $141 million, that was still high enough for the company to incur a net loss overall. Without improving its gross margins, the best-case scenario for the business is to continue shedding overhead in the hopes that it may be able to generate low-single-digit profit margins that are slightly above breakeven, but that's by no means a guarantee.

Why it may not be easy for Opendoor to succeed

Unfortunately, simply increasing its gross profit margin is no easy task. Opendoor would either need to be able to sell homes at far higher prices, or be able to find bargains to buy with minimal repairs much more easily. The former could be possible if the housing market gets red hot again and buyers are willing to overbid for homes, but to be able to do that consistently would likely be a challenge.

It doesn't bode well that both Redfin and Zillow got out of the home-flipping business due to the uncertainty in the market. Zillow's CEO at the time, Rich Barton, said "the unpredictability in forecasting home prices far exceeds what we anticipated" and that the iBuying business resulted in significant volatility. For Opendoor to succeed, it would need to find a strategy and develop an algorithm that can succeed where these two big names have failed. Without that, it may not matter how hot or cold the housing market is.

Opendoor's new CEO, Kaz Nejatian (who took over in September), plans to use artificial intelligence (AI) to transform the company's operations over the coming year. The business will aim to use AI to enhance its pricing engine, conduct marketing, and also help do in-home assessments more efficiently. It's an ambitious plan, but it's difficult to quantify what that will mean for Opendoor's bottom line. And while leaning on generative AI can sound exciting, investors shouldn't assume it will lead to profitability as many companies are still struggling to show a pay off from AI investments.

Is Opendoor's stock worth taking a chance on?

Opendoor's stock is up around 410% this year (as of Sept. 29) as it has been a hot buy, largely a result of speculation. It's unfortunately not much more than a meme stock these days as the company's financial performance has not given investors much of a reason to remain optimistic; the company has incurred a net loss in each of its past four quarters and without a significant improvement in gross margin, that's not likely to change anytime soon.

Even if you have a high risk tolerance and are comfortable with buying meme stocks, you should tread carefully with Opendoor given its surge in value this year. With such significant gains already, there could be a lot of room for the real estate stock to fall.

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David Jagielski has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Zillow Group. The Motley Fool has a disclosure policy.