Description

Realogy – Long Idea

Opportunity:

Realogy currently trades around $20-21 and I believe it could be a double in the next two to three years. At the current price levels, you are earning a mid teens after-tax levered free cash flow yield with that cash flow being mostly deployed into stock repurchases at these attractive levels. You get paid to wait while the new CEO and his management team start to turn the ship and improve the Company’s operating performance. Despite lots of new competitors and capital entering the industry, Realogy retains an enviable position with the largest market share and well recognized brands. The recently appointed CEO, Ryan Schneider, and his team will with better leverage Realogy’s industry position with better deployment of technology and customer segmentation, both areas he deployed effectively at Capital One. 

Business Overview:

Realogy (ticker: RLGY) is the largest operator of owned and franchised residential real estate brokerages in the US, and the business also has an international presence. Realogy has four main business units: 1. Real Estate Franchise Group (“RFG”) which is the franchisor for well known brands like Coldwell Banker, Centrury 21, Sotheby’s, and ERA; 2. NRT which is their company owned real estate brokerage business where they are a franchisee of brands like Coldwell Banker, and they also own proprietary brands like Cocoran and ZipRealty; 3. Cartus, which is one of the leading providers of employee relocation services; and, 4. TRG which provides title and settlement services. Realogy’s various business units provide the company and their agents multiple ways to participate in the real estate value chain including the agent commission, title fees, mortgage origination referral fees, and corporate relocation. Realogy’s RFG and NRT represent the most important part of the business given they collectively generate over 80% of the combined Company’s EBITDA before corporate overhead.

Realogy was a subsidiary of Cendant and it was effectively built as a M&A roll-up of real estate brokerage and related services, until the business was spun-off into a standalone public company in 2006. The business was then taken private again in 2007 by Apollo and spent the next five years fighting for its survival with a heavily indebted balance sheet and a significant drop in earnings due to the housing collapse. The business was taken public again in late in 2012. While the management team did an enviable job operating the business under severe distress, you could fairly characterize Realogy as a financial engineering company for most of its history from the Cendant roll-up days through the Apollo LBO and subsequent balance sheet repair. The business had been led by Richard Smith for 21 years, including 10 years as the head of Cendant’s Real Estate Service Division. In the fall of 2017, Realogy announced that Richard would retire as both Chairman and CEO with Ryan Schneider becoming CEO in December 2017. Prior to joining Realogy, Ryan ran Capital One’s card business, its largest and most profitable unit, since 2007.

Upon becoming CEO at the end of 2017, Ryan has quickly made a number of senior management changes including bringing a former colleague at Capital One to become Realogy’s Chief Technology Officer and changing the senior leadership at several of the key brands. Ryan also has articulated some key changes in strategic direction versus Realogy’s historical approach, namely: 1. A focus on Organic Growth, not acquisitions; 2. Leveraging Realogy’s scale to invest in their technology including a focus on big data (which he helped lead with great success at Capital One) to improve the overall value proposition to their agents and 3. Using excess cash flow for stock repurchases. 

Thesis:

• Leading Market Share in a Business with Great Returns on Tangible Capital and High Free Cash Flow: Looking at RFG and NRT on a combined basis, Realogy participated in almost 1.5 million residential sides (there are two “sides” to each transaction) in 2017 making it the largest in the US with roughly a 13% market share. Realogy’s brokerage and franchisees also skew towards more expensive housing areas so on a transaction value basis, their market share is closer to 16%. Realogy’s businesses are capital light and combined with strong free cash flow characteristics, the business’s return on tangible capital is well over 100% (its reported ROIC is much lower due to significant historical goodwill and intangibles from their roll-up days). 
• New Management team that is changing the direction of the Company: Ryan Schneider become CEO of Realogy in December 2017, taking over for long-term CEO Richard Smith. Studying Ryan’s track record, he has deep expertise around customer segmentation and data & analytics which are both needed at Realogy. In some ways, its amazing Realogy has largely held onto it’s agents and market position the past five years despite being managed for a long-time with a financial engineering mindset (ie, focused M&A and servicing a significant debt load). Ryan has clearly articulated a big strategic shift and moved quickly to make numerous senior management changes. The team is aligned with shareholders given a significant portion of their compensation comes in stock and/or is based on stock performance (it’s an overly generous comp package but the cost is factored into the Free Cash Flow yields). 
• Attractive Industry Position: Realogy’s revenue and earnings are basically a royalty or commission on a brokerage/agent’s overall commission dollars. Despite significant worries over time about the role of the agent, real estate agents are still involved in about 90% of all residential transactions, which is actually up from 10 years ago. In addition, many of the new industry entrants (discussed in more detail below) started out with the plan to displace the role of the agent, but most have come full circle to now embracing agents as critical to the value chain. While the transaction fee % comes down a few basis point each year, overall transaction values have grown at about an average of 7% since 1972 (and the past five years have been similar) with 2% sides growth and 5% price growth which has led to overall industry commission dollars growing nicely. 
• Realogy trades at Free Cash Flow Yields that Imply Secular Decline: Realogy currently trades around a 16% 2018 levered after-tax free tax flow yield and closer to 12-13% when normalizing for the roll-off certain tax attributes by 2020. The Company also trades at a little under 10x EBIT after adjusting for about $100mm of acquisition related amortization. The Company is taking advantage of the current stock price weakness to repurchase stock and has repurchased about 6 million shares between February 2018 and July 2018 which represents about a pace of about 9-10% annual reduction in share count – they are becoming a cannibal!

Industry:

The US residential real estate industry is a huge industry with annual transactions of about 5.5 million (so 11 million “sides”) and total annual transaction value of $1.6 trillion. The average commission in the US is around 5% so that implies a total fee pool of roughly $72 billion (assuming agents are involved in 90% of transactions). And that doesn’t include any of the related fees like title, mortgage origination, relocation, etc that Realogy can also participate in. For most people, buying and selling a home is the most important transaction they will do in their lifetime and a real estate broker is a key advisor throughout that process. In some ways, the broker under “monetizes” the relationship they build up during the transaction since there is no real opportunity for capturing additional fees over time other than on their client’s next move. Despite years of M&A and consolidation, the residential real estate brokerage industry in the US still remains fragmented with thousands of independent brokerages. The three largest players in terms of transaction sides currently are Realogy, Keller Williams, and Re/Max with a combined market share of “sides” of around 30% and that share is up, not down over the past few years.

While it’s a large and highly profitable industry, it’s fair to say that the industry has seen slower adoption of technology than many other areas of financial services. So not surprisingly, the industry has seen a tremendous amount of new competitors and private capital enter the industry over the past five years. For over the past twenty years, the industry has been seen competitors very successfully grow through models offering larger payouts / revenue splits for agents, with Keller Williams and Re/Max being two very successful examples. On the other hand, the industry has also seen numerous attempts by new entrants to try to gain share by offering lower fees to consumers but that has been met with very limited success. But more recently, the pace of innovation and the deployment of technology has increased noticeably and we are still in the early innings. For example, Zillow has built a very profitably model geared to lead generation for residential brokers. But more recently, a number of new “technology-enabled” competitors to Realogy have gotten some traction including companies like Compass and Redfin. Interestingly, while many of these new entrants started with the idea of partially or completing displacing the traditional agent, almost all of them have now realized they need agents to gain real market share and have altered their approach to market. The bad news for the incumbent players (like Realogy) is that has put increased upward pressure on agents commission split due to the increased competition for productive agents. In addition, the industry has also seen completely new business models like IBuyers.

I don’t think there is any question that the industry will evolve and the effective deployment of technology will be critical to enabling agents to better serve their customers. But that technology can be best leveraged with a scale group of productive agents and with access to large amounts of data (Realogy has both). Some of these new entrants are certainly here to stay, and at a minimum, they will continue t to make the recruitment of agents highly competitive. But just to put it into perspective, even the “successful” new entrants (eg, Compass, eXp, Redfin) have not been able to demonstrate consistent profitability so the juror is still out on their long-term economics. Second, while they are posting big growth numbers, the overall inroads to date have been manageable. For example, Redfin has received much fanfare and its growing transaction sides at 25-30% but their overall market share is currently around 70bps and they have been only adding about 10bps per year in share. 

Valuation:

• Key Stats: 
o 124mm share outstanding and about 4mm of additional incentive comp dilution. Trading at about $21 per share so roughly $2.7 billion market cap. $3.4 billion of net debt (including about $200 million in cash and excluding about $260mm of securitization financing) so a little under $6.1 billion EV
o Trailing EBITDA of $717 million. Roughly $100mm in CAPEX (vs $200mm in D&A). Almost no cash taxes currently due a significant NOL but that will likely be fully utilized by sometime in 2020. So next 18 months, roughly $430 million in After-tax Levered Free Cash flow annually and more like $340 million with normalized taxes. Worth noting those numbers include the burden of about $55mm of stock comp expense. The company has been issuing 2-3 mm management incentive shares per year (not all have vested due to stock price performance) but at $20 per share, that $55 seems like a fair deduct to Free Cash Flow or Owners Earnings. 
• Key Metrics: Currently trading for 16% current year’s Free Cash Flow of $430 million and more like 12.5% with normalized Taxes. Also trading for under 10x EBITDA – CAPEX – Securitization Interest
• Two Years Out: Over the next two years, they should repurchase at least 20mm shares ($300mm per year and assuming stock price appreciates from $20 level to around $30). After adding roughly 5 shares of dilution from management incentive plans, you would have 113 mm shares so 12% lower than today’s fully diluted count. They will also have some debt paydown from Free Cash Flow in excess of stock repurchases. Assuming a franchise like this should trade at something at least closer to a 8% levered free cash flow yield (a little less than 10x EBITDA) and assuming management grows EBITDA 3-5%, that should translate into a $37.50-$40 stock or about a double in two years. If earnings are flat or decline slightly and assuming a 10% free cash flow yield, the stock should still trade for $25+ a share which is far from exciting but not a bad downside return and you still are collecting a 10+% free cash flow yield going forward. And even the base case of a 2x ascribes almost no incremental value to management’s ability to operate the business better than their financial engineering predecessors
• Industry Comparable Valuation Metrics. I believe any way you look at the industry valuation metrics would imply Realogy is worth considerably more than current levels. Two examples:
o Valuation of just the RFG business unit: Re/Max, its publicly traded comp on the franchise side, currently trades at 14-15x EBITDA with similar margins and with no tax attributes. Applying that multiple to just RFG’s EBITDA would imply RFG alone is worth roughly $8bn or more than the current EV. Even if you burdened RFG’s $570mm of EBITDA with the full $90-100mm of corporate expense, would still imply almost $7bn of value and you are getting the other divisions for free which have roughly $240mm of EBITDA
o Valuation of NRT: Granted, NRT’s profitability has been under pressure due to increasing payouts but they are now appear around competitors levels on both agent payout split and company EBITDA margins. There are three competitors that have all started in past 5-10 years and have an observable valuation: Compass, Redfin, and eXp. Compass raised private capital at a $2.2 billion valuation, Redin and eXp are both public and have an Enterprise Value of roughly $1.5 billion and $1 billion, respectively. None of these companies are currently profitable when including stock comp expense (which is a real expense to keep their employees and agents). They are all growing nicely but to put it into perspective, the companies combined did about 87,000 transaction sides in 2017 and they had a combined valuation of about $4.7 billion. NRT did 344,000 transaction sides so roughly 4x those three firms combined. To be clear, those 3 competitors will have significant sides growth in 2018 and I’m not suggesting NRT is worth anywhere near 4x their combined valuation (would be almost $19 billion for NRT alone), but I think it helps put in context the current Realogy valuation disconnect at a $6 billion enterprise value. 

Why Is it Trading at These Valuations / What is the Bear Case?

I believe there are three main reasons for the market’s negative current view of Realogy:
• Realogy’s EBITDA is assured to be down in 2018 vs 2017: Realogy has been experiencing material margin compression in their Company owned brokerage business (NRT) due to pressure on the % revenue splits with their agents. In short, I believe Realogy was really overearning the past few years (since their primary focus was on rightsizing their capital structure) by clearly being off market on revenue splits and they are now getting back to being inline with market. Their payout at NRT has gone from roughly 68% in 2016 to 71% June 2018 TTM and their EBITDA margin (after eliminating the intercompany franchise fee they pay RFG) has gone from 10.4% to 8.7% over the same period. Both the agent payout level and EBITDA margin now look much more around market. There will likely continue to be some pressure on overall industry payouts (explained in Risks Section) but the worst is behind them.
• Fear that Realogy is the Dinosaur in an Evolving Industry: The US real estate industry is seeing a tremendous amount of capital flows and new entrants. Examples include entrants in Lead Generation (eg, Zillow), Technology Enabled Brokerage (eg, Compass, eXp), Low Commission Technology Platforms (eg, Redfin), IBuyers (eg, Zillow, Redfin, Offerpad,). Despite all the new entrants, the data would suggest that 1. People still want to use an Agent (~90% use agents and that number is up, not down from 10 years ago) and 2. The commission rate drops a few basis points a year but that is not a new trend and is more than offset by home price appreciation (ie, $ commission per transaction still increases). And while the industry is ripe for more deployment of technology to help agents and home buyers, that technology requires scale and data which Realogy has both. Realogy already spends $200mm a year on technology across their platform which is about the total revenue of Re/Max, one of their largest competitors on the franchise side. And having the #1 markets share, Realogy already has one of the biggest data sets in the industry and I believe the new CEO and his team will much better leverage that asset going forward (as he and his CTO did at Capital One).
• Fear that Recent House Price Appreciation is Not Sustainable and Could Lead to a Downturn. That then Combined with Realogy’s Leverage of Roughly 4.7x EBITDA: There is widespread discussion around the limited inventory of homes for sale which has led to a seller’s market and increases in homes selling prices. In addition, there are clearly some markets that have seen prices far outpace affordability. And to make matters worse, the potential impact of the tax reform (limited mortgage interest deduction and the SALT limitations) and rising interest rates have put further strain on home affordability. That said, the overall price increases the past few years haven’t been significantly outside the historical norms. It’s also worth noting that since 1972 (the farthest back NAR keeps the data), home prices have increased about 5% per year. While that may seem high, that number is a little bit misleading since the mix shift of more expensive new homes elevates that number. When looking a more apples to apples price appreciation like the Cash-Shiller Index, the average price growth has been closer to 3.7% since 1987 so roughly 100bps over inflation over that same time period. And while the number of sides has been basically flat this year, at about 5.5mm transaction per year, we are not outside historical trendlines (vs almost 7 million at the height of the housing bubble and with a smaller population). That said, the market could turn over for some period, but Realogy should be able to manage through any downturn. The Company’s debt has good tenor with only $450 million maturing through 2020, and the senior debt covenants provide significant cushion with Senior Leverage Covenant of 4.75x versus a current actual level of 2.7x. In addition, Realogy could quickly redirect its free cash flow to deleveraging if needed and the CEO has already managed running a large credit card business through the financial crisis.

Potential Downsides:

• New Entrants put Increased Pressure on Broker Payouts: Despite my view that Realogy can hold its own against the new entrants, the new entrants could still put additional pressure on agent payouts. While many of the new entrants started out thinking they could displace the broker, most now realize they need the broker in the transaction. As a result, you have many new entrants (like Compass and eXp) aggressively trying to recruit agents including enticing them with stock options, etc. After raising about $800 million last year, Compass had been the most aggressive on the high end of the market, but they have now realized its more economic to acquire firms than recruit individual agents which should be good news for Realogy.
• IBuyers get real scale: While the IBuyer trend is still immaterial to the industry, if they get real momentum they could shrink the overall brokerage commission pool since in many cases the IBuyers don’t pay a buyside commission (they keep it effectively) and they would have significant negotiating leverage on hiring brokers on the sellside. That said, the IBuyer model seems most applicable in lower priced homes (<$300k) where they are relatively cookie cutter and they can do large relatively homogenous volumes, so that overall impact on commission dollars should be more muted. And the model hasn’t been tested yet for a real downturn.
• Housing market turns quickly: The housing market could turn which would clearly hurt Realogy’s near-term earnings and cash flows. I would be surprised if there was a big pullback given the current strength of the consumer but it could certainly happen. Even with a pullback, the current run rate of about 5.5million annual home transactions seems like a good average so while earnings would go down in a downcycle, you are buying more or less off of a current normalized earnings level over a cycle.

Catalyst

• New Management’s Strategic Direction becomes Clear to the Market: Ryan inherited a tough first year since earnings were ensured to decrease as the increasing payouts at NRT rolled through the financials. But that trend should significantly abate by end of 2018 / early 2019 and Management has already communicated a bunch of new initiatives that will be introduced in 2019, including one or two new franchise platforms and a simplification of the agent payout structure which should materially help recruiting (Realogy is still living with many historical compensation structures from acquired brokerages). I would also expect more announcements around customer segmentation, big data, and technology to come over the next 12 months. 
• Substantial reduction in share count + moderate organic growth drives strong growth in intrinsic value per share: At the current stock price, Realogy can continue to reduce their shares outstanding by 15-20% (before management incentive compensation dilution) over the next 2 years. Even if they only reduced the share count by 15% and EBITDA stayed completely flat, you still have a levered free cash flow yield of about 12% when they become a tax payor in 2020.