Description

HFF is an extremely well run commercial real estate broker with a private partnership mentality and high employee ownership. The company focuses on its core business and avoids conflicts of interest with its clients, and has a pay for performance incentive structure that is heavily based on regional office results. This has allowed the company to consistently take market share – from the peak of last cycle in 2007 to 2016, HFF’s investment sales volume increased 115% compared to a decrease of 14% for the industry, and debt placement volume increased 73% compared to an industry decline of 2%. The business model is asset light and highly profitable in most years. Balance sheet has net cash. Mgmt is very shareholder friendly, paying a special dividend close to annual EPS in each of last 5 years. In many ways, HF reminds me of EXPD, and the stock trades at 15x trailing EPS.

There is only one problem, albeit a YUGE one – where are we in the commercial real estate cycle and how much would EPS fall? It is safe to say we are closer to the end of the cycle, and a downturn will wreak havoc on HF’s financials. The last down cycle in ‘08/’09 was not pretty as volume/revenue were down 50% in back-to-back years, although HF regained prior peak in 2012, while the industry still has not fully recovered. I have followed this company for over a year and planned to write it up, but it is this fear that had prevented me from pulling the trigger. In fact, I was licking my chops last month when a sell-side analyst downgraded the industry quoting industry volume down 20%+ in Jan/Feb. Instead, HF reported 18% revenue growth in Q1 vs. industry volume down 18%. These guys clearly are doing something right, and I have partially capitulated and decided to follow the old Peter Lynch rule when dealing with high quality companies trading at high valuation/wrong part of the cycle – buying a “dink” position and hope/root for the next downturn. There are reasons to believe this down cycle will be nowhere close to the viciousness of last cycle, and I have high confidence that HF will continue to take market share as they follow the existing playbook and methodically expand into new geographies. Normalized EPS power should be much higher than the $2.25 peak EPS this cycle, and stock will follow earnings higher.

 Business Overview HFF operates as a pure play broker in the commercial RE market, and primarily offers debt placement, investment sales, and commercial loan servicing. The company spans 23 offices in US and expanded into London in Jan 2017 via a seemingly well timed/opportune acquisition right after Brexit. HFF charges a commission for its advisory service for each transaction, with debt deal priced less than investment sales due to shorter turn-around time. Investment sales volume were $37B in 2016, a 7.6% market share (#3) vs. $17B and 3% in 2007 (#5). Top 5 brokers accounted for 45% of total market share. Debt placement volume were $41B for HFF, a 8.2% market share (#2) vs. $24B and 4.7% in 2007 (#2). Top 5 players accounted for 32% of market share.

The market share gain is quite remarkable, and it cannot be explained by undercutting competitors in prices. Mgmt would attribute it to a few things. 1) Unlike many of its competitors, HF focuses on transactions only and does not provide any ancillary services like asset management, which mgmt believes is a key selling point and gains goodwill due to lack of conflict. 2) Pay for performance compensation structure where the key producers in each regional office gets a large share of what they make for the firm. 3) A player/coach model style whereby the firm's senior partners would mentor home grown talent and hand off clients to young people becoming producers (most of new hires in recent years have been fresh grads). HF clearly focuses on organic growth, in contrast to the much more acquisitive CBG/JLL. 4) An owner mentality versus an employee mentality, illustrated by the fact that HFF employees own approximately 12.7% of shares.

Quite simply, HFF management has built a better mouse trap – taking tremendous market share over the last 10 years (all organic) and gradually growing footprint (Seattle, Phoenix and London being the latest three). The pure play asset light model also leads to industry leading EBIT margins (20%), high ROE, little capex/WC needs, and high FCF approximating net income. Balance sheet has $100m+ net cash after adjusting for an offsetting Mortgage Notes Receivable asset and line of credit liability. Most of the FCF had been paid out in the form of “special” dividend which had occurred each of last 5 years, totaling $320m.

The elephant in the room is obviously where we are in the cycle.  

Management would give a few mitigating factors, including 1) commercial RE becoming a bigger allocation of capital (reflected by the new S&P sector code), and a doubling of AUM held in closed and open ended funds since 2007, 2) 1.07 trillion of maturing commercial RE loans that need to be refinanced through 2019, and 3) yield spread still ways off from 2007 level. To certain extent, the industry has already seen a down year in 2016 and a down quarter in 2017. HF’s stock has also stagnated for 3+ years, so some of the de-rating at end of cycle has already happened. Mgmt has also chosen to invest heavily in technology and headcount last two years, and have repeatedly said they could report higher EPS at the expense of LT opportunities, so 2016 op margin took a 300bps hit and peak EPS for this cycle (assuming it had ended) is closer to $2.50. Ex cash, 12x prior peak EPS does not feel outrageous for a company of this quality, especially considering future growth potential and relative to rest of the market (famous last words). With that said, I think position sizing would be the key here, as I would welcome the inevitable downturn to load up on the stock, if it is not acquired by then. 

Catalyst

CRE cycle