This article is excerpted from Tom Yeung’s Profit & Protection newsletter dated August 12, 2022. To make sure you don’t miss anything of Tom’s picks, subscribe to his mailing list here.

“Never get high on your own supply.”

“Don’t use what you sell.”

Anyone who has watched an episode of breaking Bad Where Thread will have seen a version of this street tip before.

But don’t try to tell that to corporate America.

In the years before the financial crisis, bank bosses began to take an interest in the products they were selling to customers. Subprime mortgages…Commodity futures…Credit default swaps…Those prop trading desks seemed to be asking, “If our customers are making this much money from our products, why not us?”

Zillow casts a dark shadow over the future of Opendoor

The same forces seemed to attract Zillow (NASDAQ:ZG) in the same trap. In 2018, the online real estate aggregator decided it could make more money by using its pricing algorithm to trade homes…

…and $880 million in losses later, and he also understands why I rarely recommend companies that speculate on their own products. When a company specializes in market making, alarm bells should ring if it starts to “get high on its own supply”.

But what about open door (NASDAQ:OPEN), a company that specializes in the trading of these assets? Is this in the same boat as the accessory merchants who brought down Zillow’s iBuying program?

The problem with Opendoor’s business

Opendoor is an iBuying real estate company that aims to streamline the residential real estate industry. In 2021, the company sold over 21,000 homes and generated $8 billion in revenue.

By all growth metrics, this company should look like a slam-dunk winner. The real estate market is notorious for its inefficiencies. On average, buyers take 30-45 days to close a home, and Opendoor provides an alternative that can close homes in as little as 14 days.

For homebuyers, the company also offers significant savings. DIY buyers can view homes without agents, saving thousands in brokerage fees. No surprise OPEN has recorded a compound growth rate of 83% since 2017.

Still, all is not well with the growing startup, as its “C-grade” quality score shows.

This is because OPEN works much like carvana (NYSE:CVNA) in autos today, or prop-trading banks in subprime mortgages in 2007:

He get high on his own supply.

In the second quarter of 2022, Opendoor recorded $6.6 billion of real estate on its books, or about nine months of inventory. These homes, in turn, are backed by approximately $6.5 billion in asset-backed debt financing. It’s a powder keg of leverage ready to explode.

As good as its pricing algorithms are, OPEN’s balance sheets will not escape a real estate crisis.

All other things being equal, a 10% gain in house prices would increase the company’s equity value by $660 million, while a 10% loss would do the opposite. You don’t have to be a real estate speculator to know that such high loan-to-value ratios are a recipe for disaster.

A Black Swan event hidden in plain sight?

These risks have not gone completely unnoticed. Since November, Opendoor shares have lost three-quarters of their value as investors reconsidered the company’s debt positions.

Source: Thomson Reuters chart source

If real estate prices increase by 17.5% in one year and your business still loses $274 million, something is clearly wrong.

But the management of Opendoor seems oblivious to these fears. Its annual report highlights interest rate risk as its only significant concern; management ignores the price risk of its inventory of 13,000 homes. And the company publishes no stress test reports — a major red flag for a company that has nearly as many finished homes as America’s largest homebuilder. DR Horton (NYSE:DHI).

These are clear red flags. A fall in real estate prices will be reduce the book value of OPEN inventories. And such a drop will have repercussions on the company’s finances. If the company’s equity base shrinks, it could trigger loan covenants, causing even more downgrades to the company’s credit, and so on.

It should surprise no one that OPEN’s 2026 bonds are trading at 64 cents on the dollar.

What to do with an OPEN stock?

None of this means Opendoor can’t succeed. Commodity giant’s mature enterprises glencore (OTCMKTS:GLNCY) to the Japanese conglomerate Marubeni (OTCMKTS:MARUY) have long used their dominant market position to earn billions from the accessories business. And Opendoor’s position as a real estate marketplace could one day make it an “Amazon of real estate.”

But the promising business does not make the core Benefit & Protection “buy” list for its financial risk.

Instead, two tech-focused real estate companies make the list. One is already up 40% since I recommended it last month. This is an asset-light real estate brokerage that I highly recommended as a tactical play on short-term house prices.

The other company is a longer-term strategic investment that rose 8%. Buyers still have plenty of time to get into this slowness.

To stay up to date with these selections, click here to subscribe to Tom Yeung’s Benefit & Protection.

Take Opendoor’s finances with a grain of salt

Scan OPEN’s financial records and investors will quickly see a series of red flags.

Assumptions that interest expense will remain at 1%…

…A growth rate that seems too good to be true…

… A $62 million fine from the FTC for “deceptive” marketing…

The list continues.

Sometimes startups can overcome these obstacles through sheer willpower. Companies of Amazon (NASDAQ:AMZN) at You’re here (NASDAQ:TSLA) took a “fake it ’til you make it” attitude to raise billions in cheap capital and thrive.

But often these types of companies go bankrupt like Pets.com or Henrik Fisker’s first electric vehicle company.

Now, InvestorPlace Eric Fry has compiled a list of 25 other popular stocks he considers “doomed companies” that are “almost certain to underperform over the next few years.” And that’s part of a presentation you should see today.

To learn more, click here.

With black swan events seeming to be happening more often than ever, it’s important that long-term investors also play a strong defense.

Tom Yeung is the editor of Profit & Protection, a free e-newsletter about investing for earning profits in good times and protecting gains in bad times. To join Profit & Protection – and claim a free copy of Tom’s latest report – head here to sign up for free!

He is also the editor of Profit & Protection, a free e-newsletter about investing for profiting in good times and earning protection in bad times. To join Profit & Protection – and claim a free copy of Tom’s latest report – head here to sign up for free!