Description

Countrywide PLC (CWD LN) is a post spin-off business that is extremely cheap on both 2004 and normalized earnings and free cash flow, pays a dividend yield over 3.5%, has significant and not-yet-fully-understood catalysts for substantial growth over the next five years, and has a crown jewel of a hidden asset that could be spun-off to realize value for shareholders in the next 2 years. The CEO has also bought a ton of stock personally. For the sake of simplicity I will quote all amounts in British Pounds using the notation L1 = 1 pound = about $1.78 at current exchange rates. The predecessor company, Countrywide Assured Group PLC, consisted of several real estate agency related businesses (that are now CWD) along with a life insurance business (now CSN) that had some serious problems. In May, the company spun off the Chesnara life insurance business, whose regular blowups were masking the profitability and growth of the CWD businesses.

So now CWD is a residential real estate company with four basic businesses, and has an investment in a very successful and profitable real estate internet site called Rightmove.co.uk. The business units all overlap in the selling process of homes in the United Kingdom. They service customers who tend to be buying average priced homes (L180,000), many first time buyers, and more working-class clientele. They are the largest estate agent, or real estate broker in the country (about 6% market share); they also sell ancillary products such as insurance and mortgages throughout their agents in the local offices. They are the largest surveyor, or appraiser and inspector, in the country, which ties in nicely to the agent business, as all houses sold need a survey. They also handle conveyancing, or escrow, which is the closing process. Rightmove is the by far largest web site dedicated to the listing of residential real estate in the UK.

The management team here is world class and has done a fantastic job of generating great returns while returning much of the cash generated to the shareholders over the years through dividends and share buybacks. Included in the spin-off was a one-time special dividend of L85 to shareholders. This trend will continue as an independent company as they will pay around a 12-15p annual dividend and continue to buy back shares over time.

BUSINESSES

Countrywide has four main business segments: Estate Agency (analogous to Century 21), Financial Services, Surveying, and Conveyancing.

Estate agency is Countrywide’s most volatile business, as it is almost purely dependent on transaction volume and sales price of houses. Lately the UK has been experiencing a strong housing market, very similar to the US market, as their economy and employment situation have both been strong. As such, prices for houses have risen to record highs and are a cause for some concern. The other variable, transactions, have been pretty much at the average of historical trends.

Financial Services is a fee-based business (i.e. CWD does not take on any actuarial or credit risk) in which a finance agent working in the company’s local offices sells mortgage or some sort of insurance product to customers who are buying houses. This business is less volatile than Estate Agency as the agent typically is constrained by his own time when things are good and gets a higher hit rate when things slow down, although it does still have a correlation to housing prices.

Surveying is a great business. Countrywide is the largest surveyor in the country, with a market share of about 18%. This is basically a mom and pop business where CWD is the big national player with superior systems and cost structure. This business is very stable, because CWD generates through its partners over 10% more business than they have the capacity to handle, and panel it off (at basically no profit), which provides a huge cushion in a weaker housing market. There is also organic growth through back office productivity improvements.

Conveyancing has significant upside over the next three years as they roll out the plan that they have been developing over the last two years. Part of the plan involves a new software system that they are rolling out which will increase capacity from the current limit of 30,000 conveyances per year to about 125,000. Since CWD estate agents sell over 80,000 houses per year, you can see how quickly this capacity can get filled up and drop profits to the bottom line. The other part of the plan involves an outsourcing platform in India, where labor is cheap and fine quality lawyers are available and excited to have a job. Not only will this provide CWD with a huge cost advantage in a mundane mom-and-pop business, but they will also have service advantages like longer hours and 800 number type services. CWD be able to roll this out for purchase transactions, but also they will use this platform to build a mirror business that will handle remortgaging, or refinancing. This is a steady business (not a refi boom waiting to collapse as some people fear in the US), as almost all mortgages in the UK are fixed for 3 to 5 years with steep prepayment penalties for 2 to 3 years.

GROWTH OPPORTUNITIES AND OTHER ASSETS

The most immediate upside opportunity for CWD is the conveyancing strategy mentioned above. Conveyancing is currently losing money (mainly expenses of building out the software). Management estimates that each of the two conveyancing businesses, regular conveyancing and remortgage outsourcing, will generate L20 of EBIT in 3 or 4 years. It should generate L5-8 next year and grow steadily after that.

The next opportunity for CWD is the potential acquisition of Bradford and Bingley’s estate agency and surveying businesses that has been rumored in the press. In guessing what this could be worth, the simple math is that the surveying business is about 30% the size of CWD’s, and the estate agency business is about 3/8 the size. If those businesses can be integrated and run at CWD’s margins (a feat which CWD has achieved in the past with its acquisitions) then estate agency would add about L15 of operating profit and the surveying would add L10. There would also surely be overhead savings, as well as a positive effect on both financial services (more opportunities to sell as well as potential for volume targets from their partners) and conveyancing. In total you could easily see over L30 of incremental EBIT, which would be a complete home run given the rumored L40-50 price tag.

Another huge opportunity for CWD is the Housing Bill that is currently in the final stages of becoming law in Parliament. The bill will require all sellers of houses to complete an information pack before they can put their house on the market. Basically the idea is that all of the legal type stuff will be pre-arranged before any deal can be made on a house, which will drastically shorten the 12+ week amount of time it takes to close on a house. The effect on CWD will be threefold: First, the bill requires all houses offered to market to have a survey done in advance. This required survey would cost L400, versus the current average L175. Needless to say revenues go up, but the margins are much better on the L400 version. Second, there will be a modest boost to conveyacing. Third, there will be huge potential for Rightmove. These information packs will be a few inches thick and be very costly and cumbersome for agents to have to physically handle. In addition to being the best way to find and organize the appropriate materials, Rightmove will be able to offer an electronic option for the packs and charge an additional fee for this service. By my calculations, ignoring the potential for Rightmove and just looking at surveying and conveyancing, this Bill could easily add 15-20p of earnings, starting in 2007.

Rightmove is potentially worth a lot of money. It is currently profitable and is one of the top 10 most viewed web sites in the UK. Even without the housing bill, over 50% of house buyers in the UK access the site to do research and find an agent. Rightmove should generate about $10M in FCF in 2006, at which time the owners will probably look to IPO or otherwise monetize the asset. Given the strength of the business and the potential upside from the Housing Bill, Rightmove could easily fetch 30X FCF, which would make CWD’s 30% stake worth over 50p per share. We are getting it for free now, so it is all upside.

VALUATION

As for the valuation, I expect CWD to make about 35p this year. Looking to 2005, without any B&B acquisition, I would expect them to make 38p (based on EBIT of about L90 plus some interest income, as the company will be debt free in 2005), which assumes prices stay about where they are and there is a small decrease in the number of transactions, and a little profit from conveyancing. This is my expectation for what will actually happen (see section below on housing market), but you may want to use a more conservative “normalized” number, which I think would conservatively be about 33p. I think this business is worth 12X normalized earnings, which would be about 400p. Also backing up this valuation is that I had management walk me through the “disaster case” of post WW2 lows in both annual transactions and worst-ever housing price drop, and the company would still earn about 15p and generate FCF of ~17p, and I think the company would have to be worth at least 20X that extremely unlikely scenario.

From this base, you need to add in the growth opportunities. With a 30% tax rate and 170M shares, L10 of EBIT is worth about 4p. So adding up the growth opportunities:
- Conveyancing, growing by at least L30 in the next 3 years
- B&B, which could add L30 as it is integrated over the next 2 years
- Housing bill, which could add L40 starting in 2007-2008 time frame
- Rightmove, which I would just value at IPO value and take a conservative 30% haircut for PV and risk, which would be 35p per share.

In other words, over the next 3-5 years, the company should grow earnings by at least 40p, or 120% of current normalized earnings, just from these upside opportunities. Add to that the organic growth in the surveying business, potential growth in financial services, and growth, dividends, and/or share reduction from the company’s substantial free cash generation, and you could easily see the company earning 80p per share in 5 years, and it is pretty steady growth trajectory on the way there at a CAGR of just under 20%. So put any sort of reasonable growth multiple on that 33p, say 15X, and you get a 500p stock price. Then add in that extra 35p from Rightmove, and you get 535p, a 65% return from the current price of 325p.

So at the very least, in the near term, I would argue for a share price of 400p, even giving no credit to the upside opportunities, and I would expect the stock to appreciate toward the 500 level as some of these opportunities become more certain, i.e. the B&B deal closes at a reasonable price, the conveyancing rollout gets finished, the Housing Bill gets passed into law, etc.

Just as an extra note here, the CEO bought a ton of stock immediately prior to the spin in May at prices that were effectively in the 265-280 range. He has basically all of his net worth invested in company stock (this is why you see some transactions in the last few weeks from him where he has sold some stock, always in conjunction with exercising options that were going to expire soon, and he has sold in order to have money to pay the taxes. The one exception was a week ago when he effectively sold stock in order to send his kid to college and buy a vacation house). He is a very sharp CEO and he is on your side.

A LITTLE COMMENTARY ON THE HOUSING MARKET

Clearly your view of the outlook for the UK housing market will have a big impact on how much you like this stock. I think the stock is absolutely cheap on any common sense estimate of valuation. That said, from a trading perspective, you must realistically assume that you will always be at risk of getting jerked around by movements in the UK housing market. There are a lot of people out there calling for a crash of the “housing bubble” and if you think that is going to happen next week you might not want to be in this stock. I will give my quick 2 cents on this and let you form your own opinion, but either way if you just buy the stock and close your eyes you will make good money owning this stock.

My opinion is that the drivers of the housing market are supply and demand. Supply in the UK is extremely tight because zoning for houses has been very tight for years. Demand is driven by the economy and people’s ability to pay their mortgage. Houses are not like stocks – you don’t sell your house just because you think the market is hot, you sell it because of a life need – you are changing jobs, lost your job, got divorced, etc. As a result, housing prices are way more stable than wall street stock jockeys think. Another way to say it is that interest rates don’t drive house prices, the economy does. In the US there has never been a year over year drop in average nationwide house prices since WW2. In the UK, a slightly less diversified economy, there has been 1: in the early 1990’s, depending on the source you use, prices dropped a total of 2-10% over a period of years. This was in an environment of very high (double digit) unemployment. The current economic scenario is quite different. Prices are at historical highs, but in a reasonable economy with low unemployment there just isn’t the catalyst to make people become forced sellers and break price on their house. If you are worried about the economy weakening and blowing up the whole thing, then there are about a thousand ways to hedge that scenario.

I don’t want to turn this discussion of an undervalued stock into a drawn-out discussion of the UK housing market. But I just thought it would be fair to point out that the stock is, in the short term, likely to move with the whims of the housing market. The stock took a big dive in August because of a weak July transaction volume number. The fundamentals for this story are still very much in place, and cooler heads seem to have prevailed recently. But if you are worried about the monthly volatility, this may not be the stock for you. Unless you are a firm believer that the market is going to completely fall apart, there is still a ton of upside in CWD.

DISCLAIMER
I own CWD stock personally, as does my employer. Both my employer and I may buy and sell CWD stock whenever we want, for whatever reasons we want, and our opinions may change at any time.

Catalyst

- Completion and subsequent explanation to the market of the potential Bradford and Bingley transaction
- A half decent month of September would show that the housing market is still quite healthy
- Passage of the Housing Bill into law in the latter part of the year
- Growth in dividend that is already yielding almost 4%
- Mangement in the past has discussed the idea of taking the company private, if the stock does not move materially above current levels and they continue to execute they would definitely do it