Description

CB Richard Ellis (Ticker: CBG)      

Recommendation: Long

Current Price: $10.90

Price Target: $15.00, 38% above current

Investment Thesis

§          Market leader with limited competition of scale: CBRE is 1.9x its nearest competitor (Jones Lang Lasalle); fragmented competition in tier 2 markets presents consolidation opportunities.

§          High barriers to entry / business "moat": CBRE has made numerous large (Insignia in 2003 and Trammell Crow in 2006) and small (52 tuck-ins over the past several years) acquisitions that have helped it reach its current scale. They currently have 30k+ employees and 300+ offices in 50 countries, a footprint not easily matched.

§          Favorable long-term growth prospects facilities and property management business ("F&PM"): Management is currently putting majority of resources behind F&PM according to a current mid-level employee. The company continues to position itself as a global outsourcing leader and was ranked #8 on IOTA's 2009 list of global outsourcing companies. Longer-term, government real estate outsourcing represents a large opportunity - according to Goldman Sachs, the U.S. Government owns 22% of national real estate. CBRE currently only counts the state of Michigan as a customer, a contract which they won in July 2009 to manage 14m sq feet of properties.

§          High % of revenue is recurring in nature or from existing customers: F&PM business generated $1.7bn of LTM Q2 revenues (42% of total) and continues to add new customers in light of the recession (7 in Q2 09). Contracts are typically 3-5 years in length and include retainer fees paid to CBRE even if activity is low. Approximately 60% of CBRE's total revenues are from existing customers.

§          Distressed sellers could significantly drive real estate transaction volume in the near-term: According to Real Capital Analytics, there is currently $108bn of real estate in default globally and there are $244m of commercial mortgages maturing in 2009 across the US, UK and Japan. It is also important to note that CBRE formed an Asset Recovery and Restructuring group in 2008 to capitalize on the advisory side of this opportunity. CBRE is already managing the sale of $2.25bn of properties and management has commented that "distressed sales are expected to account for the lion's share of transactions in the 2^nd half of 2009 and well into 2010".

§          Cost structure rationalization creates operating leverage when real estate transactions pick up: Management has targeted ~$600m of cost reductions, $485m of which will hit the P&L in 2009. They have increased their target 3 times in the past year. Whenever the bid-ask between commercial real estate buyers and sellers converges, transaction volumes will increase irrespective of whether real estate prices rise to levels seen in the past few years. Because the majority of the cost base is variable (estimated 65%) due to commissions, a return of transaction volumes on a fixed cost base that is $600m leaner will be very accretive to EBITDA and EPS.

§          Low capital intensity and ROIC > WACC even in current environment: Capex has historically averaged around 1% of revenues and 10% of EBITDA, and in 2009 it's expected to be ~$30m. Rolling LTM ROIC averaged 50% from 2004 to 2007 and for the six quarters from Q1 08 through Q2 09 has averaged above 20%. 

§          Management has been accurate at predicting the current crisis: CEO cited weakening of commercial real estate market in Q4 2007 earnings call and started cost containment initiatives early in 2008 in light of being viewed as too negative by market participants.

§          Value creation-oriented executive compensation structure: 80% of executive incentive compensation is tied to meeting EBITDA targets; in light of market deterioration in 2008, no incentive compensation was paid to top executives and they've taken a 10% cut to salaries in 2009.

§          Recent amendment of credit agreement and capital raise alleviated credit risk: In March 2009 the company amended its credit agreement with the following outcome: significant covenant relief for 2 years and the flexibility to raise additional capital and buy back the TLs at a discount. In June, the company issued $450m of senior sub notes and $150m of equity ($100 of each which was purchased by Paulson & Co.). They prepaid the majority of their 2009 TL amortization payments and some of 2010 as well as had $310 of cash on the balance sheet as of 6/30/09.

§          Sell-side analyst upgrades could act as a near-term catalyst for the stock: Although a non-fundamental driver in nature, the sell-side currently rates CBRE mixed between buy and hold and the average price target is $10.75, below the current price. Increased price targets or upgrades could drive shares higher in the near-term.

Key Risks

§          Near-term downside possible if consensus view on economic recovery deteriorates: The consensus view is that CBRE will return to low single digit growth in 2010. If there are market indicators that point to the commercial real estate sector experiencing more pressure than expected, this could drive down CBRE's share price. HOWEVER...even if CBRE wasn't to return to growth until 2012, management has cited the ability to cut costs beyond the announced $600m and whenever a transaction recovery occurs will be well positioned. I believe it's not a question of "if" transaction volumes return but "when" and I would take advantage of near-term weakness in the share price to add to a position.

§          Excessive cost cuts could take a toll on employee morale and/or hinder top-line growth: This question has been asked numerous times on earnings calls and management claims there will be minimal effect on revenues from the cost cuts. I spoke with a mid-level employee that works across business functions at CBRE and he stated that (1) the majority of these cost cuts are in travel and entertainment (due to the client management nature of the business) and in today's economic environment, a customer may not be thrilled that he's getting Jonas Brothers instead of Yankees tickets, but he'll be satisfied as long as he's getting the product/service he pays for (2) there's been no change in day-to-day activities, (3) morale on the F&PM side is very high and although brokers may not be the happiest due to current commission levels, the senior ones have seen these times before and understand the cyclicality inherent in the business.

§          CBRE trades ~3.0x higher than Jones Lang LaSalle on a 2010E P/E and EV/EBITDA basis: JLL is much more concentrated in Development, Investment Management and Capital markets than CBRE (43% vs CBRE's 7% for 2008) and only has 16% of revenue from F&PM. According to my CBRE contact, two of the reasons that JLL has lower margins are (1) JLL tends to employ more ex-pats in its international offices, which are more expensive than locals and (2) JLL tends to spend more on research and non-revenue generating activities than CBRE.

§          If CBRE revenues decline by another 30% from LTM Q2 09, there could be covenant issues: A decline of 30% from LTM Q2 09 puts total revenues near standalone CBRE 2005 levels (pre-Trammell Crow acquisition, which added $1.8bn of revenues in 2005 on a pro forma basis). If this were the case I'd expect management to increase cost cutting initiatives and try to get a 3^rd amendment to their credit agreement. If no additional cost cuts were done beyond the $600m, I estimate CBRE would still generate $190m of EBITDA on this level of revenue.

§          Mandatory term loan amortization puts a drag on discretionary cash flow: 2009 prepayments are already taken care of, $52m of 2010 prepayments were made ($254 remaining) and CBRE has $310m of cash flow on the balance sheet. CBRE has flexibility to approach select lender groups to ask for loan modifications and as of Q2 09 has received preliminary commitments on $425m of debt, which will push out maturities out and extend the prepayment schedule if successful.

§          Leasing transactions are likely to decline until office rents stabilize and the economy reaches a trough: A key assumption in my model is that the downturn in leasing revenues lags a recovery in real estate sales revenues by a year. Leasing transactions did not fall off a cliff nearly as fast as sales transactions due to the fact that as long as a lessee is operating they'll need to renew their leases, and although they may be of shorter duration and lower $ volume due to declining rents, they are somewhat recurring in nature.

Valuation, Price Target & Upsides

§          I arrive at a price target of $15.00 based on Mid-cycle and DCF valuation analyses using what I believe are conservative (and below-the street) projections. See the appendix for valuation backup and key assumptions. The stock has traded up significantly since the beginning of the year (152%) due to eased credit concerns and the broader recovery in the overall market, however I think this is a still an opportunity to buy a market leader with limited competition, high barriers to entry, and good internal control over costs with a considerable margin of safety.

§          Upsides not factored into the model include (1) any increase in AUM or any carried interest revenue at all in the investment management business which should have a much higher EBITDA margin that the overall company, (2) any increase in development services revenue ($6.7bn of projects in process/pipeline as of Q2 09) and (3) any increase in capital markets/commercial mortgage brokerage revenue.

Why the equity?

§          I believe the equity is the most attractive way to invest in CBRE because (1) this is an upside play on the eventual recovery of commercial real estate sales and leasing transactions and any up-tick in volumes will accrete to the equity holders due to CBRE's post-cost rationalization operating leverage, (2) long-term growth prospects are attractive for the F&PM business which currently represents nearly half of revenues (3) there is an attractive margin of safety because the current price is 38% below estimated intrinsic value, and (4) there are significant upsides to the base case projections as discussed above.

§          The bank debt is trading very close to par (Revolver @ 98; TL A @ 98; TL B @ 96) and only offers YTMs of 6%-8% which is 450-500bps above comparable maturity treasuries. I don't find this that exciting and don't think the appropriate strategy to play CBRE is by buying the bank debt near par.

§          The senior subordinate bonds are trading above par (@ 100.3) and although clipping a ~12% yield on a relatively safe piece of paper sounds attractive, there is mostly downside from a price perspective. I wouldn't want to go long HY unsecured debt at par.

2011 Recovery Case Model Assumptions (BASE CASE)

§          Investment sales revenues moderately decline in Q4 09 and grow at 15% thereafter, never getting back to levels seen in 2003 before the Trammell Crowe acquisition

§          Leasing sales revenues continue to decline through Q3 2010 and grow at 10% thereafter. The assumption here is that general economic conditions will not see a significant recovery until 2011 and even then, it will be moderate. Leasing revenue are still $200m below 2006 levels (PF for Trammell Crow) in 2013

§          Property & facilities management revenue continues its current 5% decline through Q4 09, is flat for 2010 and grows at 5% thereafter. I believe this is very conservative given the long-term prospects of this business.

§          Appraisal & valuation revenue declines in a similar fashion to leasing revenue due to high volume and low cost of transactions. Even in an environment where the bid-ask spread is wide for properties, there are likely ongoing appraisals.

§          Commercial mortgage brokerage revenue tracks investment sales revenue on the downside but growth is capped at 0%.

§          Investment management revenue is solely fees on assets under management, which stay flat to Q2 09. There is significant upside in this business if real estate prices recover given the high margin of any carried interest revenue.

§          Development services revenue declines through Q4 09 and is flat thereafter

§          Fixed costs are approximately 35% of the company's cost base as of 2007. This assumption is based on triangulating between management's comments on earnings calls.

§          Management achieves its stated cost cutting plan, $435m hit the P&L in 2009 (conference call guidance) and the remaining $165m hit the P&L in 2010.