Description

Realogy is the largest franchisor and owner of residential real estate brokers in the country. Despite a strong macro environment, the stock has significantly lagged the overall market due to a confluence of company specific and industry factors (increased commission splits, negative impact of tax reform on SALT states, softness in key markets, Redfin/competition, hurricanes, and leverage).  However, with the stock trading at only 9.4x our estimate of normalized fully-taxed 2018E base case cash EPS (2018E FCF yield of ~15%+), 10x bear-case, and 12.6x near worst-case EPS, we believe the risks are fully priced in to the stock at this point.

We expect 2018 to be RLGY’s first year of Ebitda growth since 2015, and we believe positive earnings revisions are likely to lead to a gradual re-rating of the equity.  Applying a 15x multiple to our 2018 normalized fully-taxed cash EPS estimate of ~$2.86 produces a price target of $43 per share, ~59% upside.  We see limited downside given FCF generation and a 25%+ discount to peers on a SOTP basis.

RLGY has four businesses:

• NRT: Wholly-owned brokerages under the Coldwell Banker, Sotheby’s, Corcoran and Citi Habitats brand names. NRT is heavily focused on the coasts in major metro markets, including NY, CA, Florida, and Texas (>60% of sales.)  NRT generally caters to the high end of the real estate market with an average sale price >$500k (almost 2x the country average) and ~20% of homes sold >$2.5m in value.
• Real Estate Franchise Services (RFG): This is a capital light franchise business in which RLGY provides technology and support services along with a well-known brand name to third party owned brokerages (including NRT) in exchange for a franchise fee. Key brands include Century 21, Coldwell Banker, ERA, Sotheby’s, and Better Homes & Gardens. Unlike NRT, the RFG group is more evenly located throughout the country with an average sale price ~$285k.
• Cartus: Provides corporate relocation services and helps generate leads for RFG and NRT.
• TRG: Provides title and settlement services to both RLGY and third-party brokers and customers.

Brief history and situational overview:

RLGY’s businesses were aggregated from the 1990’s through 2005 under former parent Cendant Corp, until being spun out in July 2006.  Less than five months after the spin, Apollo announced in Dec 2006 it would buy RLGY for $9bn, or 12x forward Ebitda (EV today is ~$7bn). The housing market subsequently collapsed, and RLGY’s Ebitda dropped 65% from peak-to-trough (from $1.15bn to $411m). Apollo streamlined the organization by closing about 1/3 of NRT’s offices, cutting costs, and restructuring the debt load. Apollo re-IPO’d the company in Oct 2012 at $27 per share (same price as today). Over the ensuing 6 months, the stock reached $53 per share despite leverage north of 6x Ebitda. Apollo sold its remaining 50% interest less than a year after the IPO at ~$43.75 per share.

The company’s recent woes started in July 2015 when the stock fell 8% (from ~$50) after disappointing 2Q15 results that showed the first YoY average home sale price decline at NRT since coming public. These were the first signs that the high-end markets in NRT’s key metro regions (NYC, Miami, SF) had reached a near-term peak due to the stronger dollar, retreat of foreign buyers, and new condo inventory.  A year later, in 3Q16, although NRT returned to growth on home price sales, commission splits began to come in higher than expected, leading to margin pressure. Management noted that the company was losing key agents because it was not competitive on splits (the agent’s cut of total gross commission), so it began an initiative to retain and attract key talent, which included increasing splits. These two issues would culminate in the stock reaching a low of ~$21 just before the presidential election in November 2016.

Through most of 2017, the stock climbed steadily higher, as high-end home prices in NRT’s markets stabilized and NRT’s overall average sale price increased YoY. Commission splits, while rising, were generally within management’s full year guidance, and retention rates for key agents hit historical high-water marks (94%+).

However, in early November 2017, the stock fell almost 18% over two days, as the House issued its draft for tax reform the day before earnings. Fears began to emerge that the mortgage interest deduction would be reduced/eliminated, state and local taxes (SALT) would not be deductible, and home prices would fall, specifically in NRT’s footprint. RLGY then reported a weak quarter, with higher than expected NRT commission splits, an increase to full year commission split guidance, the first YoY decrease in RFG sides (units sold) since 3Q14, and a restructuring of Cartus’s cost structure in 2018 due to persistently lower corporate relocation volumes.

Moreover, Redfin IPO’d in 2017, selling itself as a disruptor to the industry due to its superior technology and low-cost commissions, bringing to the forefront the ever-present fear that the US brokerage market will be disrupted by technology, resulting in lowered commissions. Lastly, in November, industry bellwether RE/MAX announced the formation of a special committee to investigate allegations of wrongdoing in hiring practices and intra-company loans, causing its stock to fall 21% in one day.

In our view, at current valuations, market sentiment discounts most near-term concerns without reflecting a number of positive tailwinds for the business. Our views on the key issues are as follows:

Commission Splits:

• This is arguably the number one metric for investors to watch at this point and 2018 guidance will likely drive the stock when RLGY reports 4Q earnings (which we expect to be weak).
• Every 25bps of commission split (2017 guidance is for 70.25-70.5%, up from 68.8% in 2016) is worth ~$12m of Ebitda to RLGY. Current 2018 consensus Ebitda of $763m implies roughly a 71.0% commission split and 3% NRT transaction volume growth. We think implied splits could turn out to be too high and volume too low.
• The higher than expected 3Q17 commission split rate (and increased guidance) was due in part to mix, not solely a wholesale continued increase in split rates. The west coast, on average, has higher commission splits than the rest of the country. In 3Q17, the west coast outperformed the rest of the US, with Texas and Florida sales negatively impacted by Hurricanes Harvey and Irma. These events are not likely to repeat in 2018.
• Management believes its split rates are finally market competitive, as indicated by its high retention rates. One of management’s key objectives in 2018 is to slow the rate of increase in splits, noting on the 3Q call “in 2018, NRT management is tasked with the objective of slowing the rate of increase in commission splits”.
• Another management objective for 2018 is to improve the productivity of 3rd and 4th quartile agents, which carry a lower split rate (the more you sell as a broker, the higher the incremental split).
• Split hurdle rates for each agent are re-adjusted each year. The only way existing agents’ split rate goes higher is if they grow volume YoY and perform better than expected in 2018, which ends up being a net positive for RLGY.
• Notably, on an intrinsic value SOTP basis, higher commission splits negatively impact the lower multiple NRT business while having zero direct impact on the higher multiple RFG business, as franchise royalties to RFG are based on a set percentage of gross commission revenue (~6.5%).

Personal Tax Reform:

• The mortgage interest deduction was capped at $750,000 of principal and existing mortgages were grandfathered in. We think this turned out to be basically a non-issue for the housing market.
• The $10,000 cap on SALT deductions for individuals is certainly a negative for high-tax, high-priced real estate markets like NYC and San Fran/CA. While hard to estimate, all things being equal, it should lower home prices in those areas. But, places like Miami should benefit (no state tax in Florida) and we think a robust general economy should partially offset this.
• We estimate 40% of NRT’s revenues to be at risk here (NYC and CA share, less Miami). To frame the potential impact, if we assume that 40% of revenue sees a 10% home price decline in 2018 (with no offsetting increase in volume), and the remaining 60% sees a modest 2% increase, NRT’s average sales price would decline 2.8% in 2018. Against a base case of +2.0%, the negative impact to Ebitda would be only $14m, or 1.9% of total 2017E.

Corporate Tax Reform:

• RLGY has had a ~40%+ effective GAAP tax rate the last few years, but it has paid basically no cash taxes due to its large amount of NOLs created prior to coming public.  RLGY had ~$1.25bn of NOL’s at the end of 2016 and we estimate that will drop to ~$900m by the end of 2017.
• While most companies with almost 100% of revenues derived in the US have seen their share price increase (particularly those with the highest effective tax rates), the market has given RLGY zero to negative credit.  We believe this largely reflects the market’s fixation on the negative impact of personal tax reform on the NY and CA housing markets.
• To a lesser degree, one could argue that the NPV of RLGY’s NOLs has been lowered. However, long-term, corporate tax reform is much more meaningful to equity value than the reduction to the NPV of the NOLs (RLGY likely becomes a full-tax payer in 2020E).
• We estimate the lower corporate tax rate lowered the NPV of RLGY’s NOL’s by ~$1 per share, but it increased the terminal value of RLGY by ~$5-9 per share, or a net benefit of ~$4-8 per share. Yet RLGY’s stock declined on corporate tax reform.
• RLGY is levered ~3.8x LTM covenant Ebitda as of 9/30/17 (~4.2x actual). Cash interest expense is ~$165m annually on the current debt load.  The final tax bill limits interest deduction to 30% of Ebitda for the next 5 years (30% of EBIT thereafter). We expect RLGY to be under both of these thresholds; near term, interest expense is less than 25% of Ebitda, and in five years time we expect interest expense to drop below the 30% EBIT threshold.  

Technology/Competition:

• Clearly the biggest long-term structural risk to RLGY and all of the legacy residential real estate brokers is that technology will disrupt the current business model and lead to lower commissions (currently 5-6%). While commission rates have stayed within this range in the last 15+ years despite the rise of the internet, we generally assume these will likely trend lower, but that it won’t be immediate.
• As we discuss in the valuation section, we believe Realogy could endure the impact of a (highly unlikely) near-term 100 basis point hit to commission rates. If commission rates declined 100bps (50bps per side) in 2018 at both RFG and NRT, RLGY’s pro forma Ebitda would decline by ~$100m (from a base of ~$787m) and would reduce our normalized EPS by $0.57 (off a ~$2.86 base).
• Commission rates are counter-cyclical in the brokerage industry. When the times are good, broker competition increases and commission rates fall (especially in a low-inventory market). But when times are bad, underperforming brokers leave the industry, and consumers are more apt to go with the best, especially if they need to sell.
• Despite the fanfare that comes along with Redfin and its low-cost high-tech model, Redfin is really just a low-cost brokerage. RLGY has competed with Redfin and local low-cost brokerages for some time. Redfin has been around since 2004 and even in its home market it still has less than 5% share. Redfin agents have less incentive than traditional agents as they are paid a salary and bonus versus eating what they kill. If you are a good broker, you will want to work under a traditional commission model. Others like Compass/Purplebricks are more hybrid, but still don’t pose an existential risk.
• We would also note that despite technology platforms like Zillow, Streeteasy, and Trulia, which provide greater price transparency to consumers, the percentage of consumers (~90%) using brokerages to sell their homes has consistently trended higher. These platforms just act as outsourced lead-generators for the brokers and actually eliminate some expense by giving the consumer the ability to look at a home without wasting the realtors time.
• The benefit of RLGY’s exposure to the luxury end of the market is that these homes generally don’t have as much price transparency as lower-end homes, and the absolute dollar value of the sale could vary greatly without the proper information. We don’t see the likes of Redfin and other discount brokers being able to compete in this highly specialized part of the market, nor do we see a large increase in for-sale-by-owners here.

Other:

• New CEO. After leading the company through the financial crises, Richard Smith and much of the senior management team have turned over in the last few months. The company seems to be putting more focus on technology as a differentiator for its agents, hiring Ryan Schneider, a former Capital One executive as CEO. While we have no differentiating insight into the new hires at RLGY, we think some new, younger managerial blood will do the company some good.
• 4Q kitchen sink quarter? We think RFG’s 3Q17 YoY decline in sides was primarily a one-time impact from the hurricanes. While 4Q sides in both RFG and NRT could be negatively impacted because of uncertainty of tax reform and the hurricanes, we think 1Q could see a nice snapback.  We think 4Q could end up being a kitchen sink quarter (with investors on the sidelines until the news), but 2018 to trend positively thereafter.
• Housing a tailwind.  RLGY is highly correlated to existing US home sales. Housing inventory in the US is at historical lows. This has negatively impacted transaction sides. While a negative for housing turnover, it also means a tailwind in home prices (need to incent builders to build more homes). Ultimately, RLGY makes money on transaction volume, which is a function of price and unit volume. We think the US housing market has plenty of room to run as first-time home buyers only recently began picking up, a sign of pent-up demand from millennials.
• Balance sheet and capital allocation. RLGY is levered ~3.8x TTM covenant Ebitda (~4.2x actual). Even with this leverage profile, the company pays a 1.3% dividend, and has been actively repurchasing equity (~$375m, or ~9% of shares since 1Q16). Our model assumes RLGY repurchases ~$150m of equity per year from 2018-2020 (~4% of the current market cap per year), which still results in covenant leverage falling to ~3.3x by the end of 2018 (company goal is 3.0x) and 2.2x by 2020. We view these leverage levels as reasonable for the business given its low capital needs (capex has averaged only 12% of last three years Ebitda). Lastly, RLGY recently announced its intent to refinance and term out its senior credit facilities, which should provide further cushion.

EPS Valuation:

• Key assumptions driving our pre-tax income include +5.1%/+4.9%/+4.9% transaction volume growth, a 2.48% broker commission rate at RFG, 4.40% royalty rate at RFG, and a 70.6% commission split rate.
• RLGY has a large amount of non-cash amortization each year, while depreciation generally matches capex. Excluding this amortization, and adjusting for lower corporate taxes, and assuming RLGY is a full tax payer, we see normalized fully-taxed cash EPS of close to $3.00 per share.
• We think a 15x multiple is reasonable given RLGY’s 3.8x leverage, offset by its cash flow characteristics (>10% unlevered FCF yield). At a 15x multiple of fully-taxed normalized cash EPS, RLGY could be worth $43+ per share.
• Note that RMAX (higher multiple 100% franchisor business) trades for ~22x 2018E EPS, even after its recent share price decline. RDFN trades for 21x 2020E consensus EPS.
• In a bear case, where commission splits reach 71.0% in 2018, and home prices decline 10% in NRT’s NYC and CA markets, we estimate a normalized cash EPS of $2.68 per share. This implies that RLGY is trading at only 10x our bear case multiple.
• If we further stress the model, and assume the above, plus some new technology/competitor comes in and lowers commission rates for the entire US market by a full 100bps (50bps on each side of the transaction), normalized 2018 cash EPS would still be $2.14 (12.6x implied multiple). In our view, paying 12.6x fully-taxed cash EPS in a draconian scenario for a market leader in a decent industry (undergoing a cyclical recovery) provides a nice margin of safety.

SOTP Valuation:

• RFG is a capital light franchise business that generates significant cash flows. The best comparable is RMAX, which trades at 14.5x 2018E Ebitda (was trading for 18x+ before the recent delay of its 10Q and internal investigation). A 14.5x Ebitda multiple is very reasonable as it equates to roughly a 5.2% unlevered FCF yield on this business.
• We normalize the fees being earned by RFG from NRT in this SOTP assuming as a stand-alone entity RFG would not be able to reap the same inter-company above-market rates (note that this accounting doesn’t impact consolidated RLGY Ebitda). To normalize, we assume a 4.45% royalty rate versus the ~6.5% currently being charged to NRT.
• The value of RFG plus all corporate costs and debt is worth $18 as a stand-alone business, and would mean at the current price of $27 per share, the remaining businesses with a combined Ebitda of ~$400m are being valued by the market at only 3.0x. These businesses would be generating >20% unlevered FCF yield at a 3x Ebitda multiple.

• Our SOTP implies a consolidated 10.2x Ebitda multiple, versus the 12x Apollo M&A multiple and 12x historical valuation from 2012-2015. It would also imply an $8.05bn enterprise value. We note that RDFN and RMAX’s combined EV’s today are ~50% of RLGY’s, but together they generate only ~25% the Ebitda, even looking out to 2020E.
• There has been past chatter of breaking up RLGY to realize its SOTP value, and prior management had noted that they looked at all ways to create value, but the current structure made the most sense. While we aren’t counting on it, perhaps there will be a change in strategy with new management.

Risks

• Recession/housing market decline
• Higher commission splits
• Industry disintermediation and lower commission rates
• Disruption by new management

Catalyst

• Fears abating over tax reform negatively impacting RLGY's financials 
• Commission splits coming in lower than feared in 2018
• 2018 guidance
• YoY growth in Ebitda throughout 2018
• Continued housing price growth