Description

"I often quote myself.  It adds spice to my conversation."

-GEORGE BERNARD SHAW

BROKER: "That stock I bought for you two years ago, which has doubled?  Well, I think it's even cheaper now than it was then."

CUSTOMER: "Damn, I knew we shouldn't have bought it."

I recommended Brookfield Real Estate Services on VIC in December 2008.  Since then the price has almost doubled from $7.60 to $14.87 currently, and, including dividends received over the two years, our total return is about 136%.  That's the return in Canadian dollars; in addition, the Canadian dollar has appreciated by over 20% against the US dollar over that period.  (All prices and amounts in this report are in Canadian dollars).  Yet, in some respects, I consider the stock to be better value today than it was two years ago, in part because the risk is significantly lower, and I believe that it is a stock that can provide a total return of 100% to 150% over the next three or four years, through a combination of capital appreciation and dividends. 

(Please note that in addition to my previous write-up, the company has been written up two other times, most recently by otaa212 in January 2010, and originally by trev62 in November 2006 under its prior name, Royal LePage Franchise Services.  I urge you to read all three prior reports if you find the idea interesting.  I will avoid repeating much of the background information provided in the three previous reports, so please read them to get that background.)

Let me summarize in a few points why I like this stock today:

• We are paying only 9.4x trailing fully-taxed cash earnings;
• For a growing company with superb economics and a strong balance sheet;
• Which is a market leader;
• And has a dividend yield of 7.4%.

To me this feels like a situation with very little downside risk and significant upside.  Although the price is almost double the level of December 2008, there is much less uncertainty surrounding the global economy and its potential impact on Canada.  Also, with the conversion to a corporate structure, and the announcement of the new dividend level of $1.10 annually, another major unknown has been eliminated.  The investor base has historically been investors looking for income and thus attracted to income trusts.  I think that it is only a matter of time before a broader base of investors "discovers" that this is a growth company with outstanding economics, and paying a very high dividend to boot.  With modest growth assumptions, I calculate a potential annualized rate of return of 22% to 31% over the next three to four years.

Background

Brookfield Real Estate Services Inc. provides services to residential real estate brokers in Canada.  The company controls three residential real estate brokerage brands: Royal LePage, which is a national brand; Johnston & Daniel, a high-end boutique brand serving the Toronto metropolitan area; and La Capitale Real Estate Network, which serves the province of Quebec.  The company does not own any brokerage offices, and instead franchises these three brands and collects franchise fees from the brokers who use its network.

The company has steadily grown its base of realtors, from about 5,000 in 1995 to about 15,600 today.  Its market share has also grown, and it has over 15% of the realtors in Canada in its network now.  Because its realtors are far more productive than the average Canadian realtor, the company's network has an approximately 22% share of the residential real estate resale market, based on transactional dollar volume.

Recent Developments-Conversion from Income Fund to Corporation

The company has been an "income trust" since its IPO in August 2003, a structure similar to REITs and MLPs in the U.S., where no income taxes are paid at the entity level, but the vast majority of profits are required to be distributed to shareholders, who pay taxes on the distributions received.  With changes in Canadian tax laws kicking in on January 1, 2011, the company has now converted to a regular tax-paying corporation, and is no longer required to distribute any of its profits.  The distribution rate was increased from $1.10 annually at the time of the IPO in 2003 to $1.40 in 2008, 2009 and 2010.  (In addition, the company made special year-end distributions of $0.04 in 2009 and $0.20 in 2010 because profits were high and the special distributions enabled the company to avoid paying taxes.)  With the change in the tax laws, the dividend rate was reduced to $1.10 effective January 2011.  The CFO explains that the board chose this amount because it approximates the dividend paid previously less the tax rate that will be paid on profits starting this year.  The business is not capital intensive, and some large institutional shareholders like receiving the cash, so the company accommodated these investors by reducing the distribution by a relatively small amount.

My guess is that the dividend rate will not be increased for the next few years, although the CFO says that they will consider raising the dividend if they do not find attractive investment opportunities and cash piles up on the balance sheet.  For purposes of my analysis, I assume that the dividend will be stable at $1.10 annually for some years.

Financial Performance

My prior write-up on VIC, and the other two write-ups, discuss the nature of the company's revenue streams and the different expenses of the business, so I won't repeat those details here.  The important points to note are: (1) the annual revenues have increased steadily, with a decline of less than 2% in 2009 (though revenues in some quarters in the recent recession were down significantly); (2) margins (as reflected in "distributable cash", which excludes amortization) are very high, in the region of 70%; and (3) because of the non-capital intensive nature of the business, the company has grown despite paying out 70-80% of this distributable cash every year, while taking on modest debt.

Impact of Corporate Taxes

With the changes in Canadian tax laws, and the conversion to a corporate structure, Brookfield will start paying corporate taxes on its profits this year.  The company will, for practical purposes, be taxed on the "distributable cash" number in the table above, after deduction an amount equal to 7% of certain outstanding intangible assets, an amount which is approximately $75 million at end-2010.

Trailing 12 Months Pro-Forma Fully Taxed Profits

26.1     Distributable Cash (TTM to 9/30/10)

(5.3)    Tax Shield

• 20.8 Taxable Income

5.9       Taxes (at 28.5%)

20.2     Cash Profits (Distributable Cash less Taxes)

$1.58   Cash EPS

At the current price of $14.87, we are paying 9.4x TTM cash earnings.  I consider this to be an extremely attractive price for a growing business with very favorable economics and a strong market position.  Note also that the dividend of $1.10 is comfortably covered by this earning power, with a distribution rate of 70% based on current earnings. 

At the current rate of earnings, the company will be retaining about $6 million of profits per year, which is more than adequate to finance the annual "acquisitions" of realtors from its parent company.  For example, on January 1, 2011 it acquired 247 brokers at a cost of $3.5 million.

The Canadian government has established corporate tax rates of 28.25% for 2011, 26.25% for 2012, 25.5% in 2013, and 25% in 2014 and thereafter.  I assume in my analysis that the government will not change these rates, though modestly higher rates will not materially impact my argument.

What kind of growth can we reasonably expect going forward?  I think that the base of realtors can grow at perhaps 5-6% annually through a combination of organic growth and annual acquisitions from the parent company. This should translate to revenue growth of about 8% annually, and a commensurate rate of growth in "distributable cash".

2014 Projected Income

35.5     Distributable Cash (growing at 8% CAGR from 2010)

(5.0)    Tax Shield (I assume it declines modestly)

• 30.5 Taxable Income

7.6       Taxes (at 25%)

27.9     Cash Profits (Distributable Cash less Taxes)

$2.18   Cash EPS

What's an appropriate multiple for this?  I'm inclined to agree with otaa212, who argued a year ago in his report that "a mid-teens multiple of fully taxed FCF is appropriate, given the attractive business characteristics and long-term prospects for free cash flow growth".  Using his multiples of 12x to 16x gets us a price range of $26 to $35 in, say, mid-2014.  Throw in 3.5 years of dividends at $1.10 per year, and we get another $3.85, for a total of $30 to $39.  Over three and a half years, that translates into an annualized total rate of return of 22% to 31%, starting from today's price of $14.87.  A meaningful portion of this return is in the form of dividends, which should provide a cushion for the stock price. 

Also, if the company does indeed earn something like $2.18 per share in 2014, and does not increase the dividend, the payout ratio will be closer to 50% by then, versus 70% today.  It will then be retaining about $13 to 14 million annually to fund annual acquisitions and any other acquisition opportunities that arise.

(I think there is a reasonable possibility of a large acquisition over the next few years, possibly of another brand to add to the company's roster.  This could be highly accretive to earnings, but I do not assume that any such acquisition will materialize.)

Canadian Dollar

Given the relative states of the U.S. and Canadian economies, I would venture to guess that the Canadian dollar is likely to appreciate somewhat versus the US dollar over the next few years.  If this were to occur, it would serve to juice up our returns.  (Of course, the sword does cut both ways.)  This currency argument is not a critical component of my recommendation, but I personally welcome an opportunity to have some exposure to the Canadian dollar.

Risks

1. Significant decline in Canadian real estate market prices and activity.

2. Dumb acquisitions (unlikely for this management team).

Catalyst