Description

Overview

Jones Lang LaSalle (JLL) is a commercial real estate services firm providing sales and leasing brokerage, property and facility management, and investment services to clients around the world. JLL, along with its larger competitor CBRE Group (CBG), is one of only two players with global reach and a full breadth of service offering. Over the course of the past several years, JLL has shifted its business mix towards recurring revenue streams and has demonstrated the resilience of its business model. However, the market still views JLL as a highly cyclical and fragile business. We think this treatment is unwarranted. A meaningful portion of sales brokerage is indeed cyclical, but at this early stage in the commercial real estate recovery, it represents a modest fraction of JLL’s business. Furthermore, as seen in the severe 2008/2009 downturn, the mostly variable cost structure of the brokerage business means that there is little chance of it turning into a cash burning liability, even in the most dire economic backdrop. Property and facility management revenue has been benefitting from a powerful trend of large corporations deciding to outsource real estate management functions, as evidenced by this segment’s high double digit organic growth rate for the last several years. Meanwhile, through the tepid recovery of the past couple of years, JLL’s brokerage businesses appear to have captured significant market share as weaker competitors have fallen by the wayside. JLL’s earnings power has the potential to grow massively: while its outsourcing businesses are in the early phase of a long secular growth ramp, its brokerage businesses are consolidating share as the underlying industry emerges from a cyclical trough. This growth potential is balanced by an unusual degree of resiliency, which makes permanent value impairment highly unlikely. Furthermore, margins remain well below management’s medium term targets, suggesting that there is substantial scope for earnings growth even without help from the underlying markets. At $71 per share, 13x current consensus estimates of 2012 adjusted EPS, the market has created a compelling investment opportunity. Modest revenue growth, paired with management’s continued cost rationalization, should result in 2013 cash earnings per share of ~$7. A slightly more aggressive growth case could result in cash earnings per share over $10. At 14x, giving some credit for secular growth but still a significant discount to JLL’s historical multiples, these results would imply a valuation range 50-100% higher than the current price.  

JLL’s exposure to the cycle has dropped significantly over the past few years

As the cyclical components of JLL’s business have receded through the downturn, and as recurring businesses like Property and Facility Management have grown, JLL has become increasingly levered to steadier revenue streams. Consider the evolution of the sales composition over the past few years:

Note that the brokerage businesses comprised 46% of 2011 revenue, with most of that coming from leasing. Based on conversations with the company and industry participants, we estimate that in 2007, the peak year for CRE market activity, roughly 70% of the leasing business could have been considered recurring in nature, along with 30% of the capital markets business. These estimates are supported by what was seen in the market downturn. Most leasing activity is generated by the periodic expiration of existing leases, in which case tenants must find new space. The stability of the leasing business can be seen clearly in JLL’s results. Adjusting 2007 revenue for the acquisition of Staubach, a US leasing business that management said was generating roughly $375mm in revenue before it was acquired in mid-2008, peak (2007) to trough (2009) revenue decline was just 19% ($592mm + $375mm = $967mm 2007 PF, vs. $781mm 2009 actual). Sales activity, on the other hand, is generally elective. However, as the financial crisis demonstrated, there does seem to be a base level of activity: even in the 2009 trough year, JLL saw $203mm of Capital Markets revenue, 36% of the $558mm seen during the peak 2007 year. If we assume that the 2009 brokerage levels represent a base, and make an adjustment for the acquisition of King Sturge which closed in 2011, this implies that in 2011 70% of leasing brokerage revenues and 61% of capital markets brokerage revenues were recurring. While there are cyclical aspects to JLL’s business, there is much less exposure at this point in the cycle than there was in 2007. 

JLL’s stable outsourcing business is seeing strong secular growth  

Meanwhile, the less cyclical portion of JLL’s business is in a strong secular growth phase. While the last few years have been choppy for the brokerage business, the outsourcing business lines have seen a period of strong and steady expansion. Property and Facility Management has grown at a CAGR of 18% from 2007 to 2011 and now contributes roughly 25% of revenue.

Large corporations are increasingly looking to outsource costly and time-consuming real estate management functions. According to CBG, real estate related expenses represent 4-5% of revenue for most Fortune 500 companies. Outsourcing can typically reduce such costs by 10-15%: fixed real estate management expense can be lowered, and efficiencies can be squeezed out of rent and occupancy costs. Not surprisingly, a potential operating margin improvement in the 40-75bps range is very attractive to corporate management teams. The recent economic sluggishness has driven attention towards cost rationalization, and real estate expenses are a prime target. JLL and CBG, being the only two providers of outsourcing with international scope and full breadth of service, have been the beneficiaries of this trend. By all accounts, the secular trend of outsourcing property management services is creating a network effect that accrues in favor of the largest providers of commercial real estate services. While the growth has been impressive for the past several years, the trend is self re-enforcing. Moreover, there is no indication that the trend is hitting slower growth due to a “law of large numbers.” On a recent call, CBG’s CEO described this market as still being in its “infancy,” and has noted the potential for continued double digit growth into the indefinite future. CBG has also pegged the total outsourcing revenue opportunity in the $50-60 billion range, implying that current market penetration is low. Evidence of this can be seen in JLL’s recent results: Property and Facility Management revenue grew 19% in Q1 2012, vs. growth of 12% in Q1 2011, and in Q2 2012 it grew 15% vs. growth of 10% in the prior year period. On recent earnings calls, JLL’s management has noted that the pipeline for this business continues to strengthen, and therefore sees no indication that growth should slow. 

CRE cycle points to substantial potential upside for brokerage business

As discussed, the cyclical brokerage fees are a relatively minor contributor to JLL’s current earnings. But it is important to remember that this is to a large extent a function of the underlying markets that remain at relatively low levels. Unlike at the peak in 2007, there is little room to fall. US commercial real estate transaction volumes remain below 2004 levels. The table below shows the dollar volume of US office sales transactions, which make up the majority of JLL’s Americas Capital Markets business:

There are many reasons to think that activity will continue to rebound. One of the most compelling is the recent trend in office space construction. Depreciation steadily eats away at real estate supply, while population growth steadily increases demand. For balance, the market requires construction activity to replenish supply. However, additions to supply have languished at trough levels for the past few years. The following chart shows annual office space completions, both in absolute terms and as a percentage of total office inventory:

This trend is particularly interesting when considered in relation to office rents. While rents are not back to the peak levels that were briefly seen in early late 2007/early 2008, they are still at levels in line with the 2006/2007 time period, when construction activity was relatively healthy.

Despite this, supply additions have been minimal. This indicates that rents need to rise further to drive construction, and therefore keep the commercial real estate market moving towards equilibrium. Rising rents and property prices drive not only value per transaction, but also transaction volume, as investors and consumers of corporate real estate attempt to profit from the perceived contango. Such a trend would be very favorable for JLL’s brokerage business, and it appears to be underway. Though the pace is measured, the rate of sequential change has accelerated in each of the past three quarters:

While the precise timing and scale of a commercial real estate cyclical rebound will remain difficult to predict, JLL should benefit to a degree disproportionate to that seen in the prior cycle. JLL commands a much larger share of the US brokerage market today than it did in 2007.

Market share gains add leverage to potential upside

JLL has experienced dramatic share gains over the past few years. This is supported by a comparison of JLL’s Americas Capital Markets revenue to total US office market sales volumes. The chart below shows that over the 2007 to 2011 time period, JLL’s revenue as a percent of its most relevant markets increased by 2.5-3x. While JLL may have seen some benefit from improving fee structures, industry contacts say that fees have been mostly stable, implying that most of the growth has come from market share:

There are a number of factors behind this trend. During the cyclical downturn, small and mid-size firms fell out of the market, and brokers gravitated towards stability. In addition, the secular outsourcing trend that is driving strong growth for the Property and Facility Management segment has also strengthened JLL’s position in brokerage. When corporate clients adopt management services, they are more likely to use the same provider for brokerage needs as well. The clear trend of market share gain seems to confirm the presence of a positive network effect that our industry contacts have described. As a result, the next market upturn should be substantially more lucrative for JLL than those in the past.

Potential for margin expansion

Regardless of the timing of the next real estate cycle, JLL should also be able to deliver meaningful earnings growth through margin improvement. After a period of heavy investment relating to international infrastructure and aggressive hiring to take advantage of market weakness (which has paid a healthy dividend in the form of increased market share), cost pressure is now receding. Margins in the Americas segment have been disappointing over the past year due to over-hiring in late 2010. Excess costs were gradually pulled out of the business over the course of 2011, so according to management, 2012 should see significantly higher margin levels with basic “blocking and tackling.” This is already starting to be seen, with Americas margins showing sequentially higher year over year growth in each of the past three quarters. In EMEA, margins slumped through most of 2011 as management integrated King Sturge and continued to reconcile an excessive fixed cost base to the current low activity levels, but have rebounded with strong year over year improvement in each of the past three quarters. Asia-Pacific has shown consistent margin expansion since the downturn, but still remains well below peak levels. Q2 2012 was a setback in Asia Pacific margins, as the high margin brokerage business dipped relative to an extremely strong result in the prior year quarter. Investment Management is already back at target levels, demonstrating its resiliency. All in all, management sees a clear path to a 15% EBITDA margin in the medium term, vs. the 11% margin posted in 2011. Importantly, this target does not include any potential benefit from a rebound in investment management incentive fees, and it assumes steady to slightly growing revenue.

Why JLL?

Our references to CBG beg the question, why JLL? In general we like the case for CBG as well, and have invested behind them in the past. However, we prefer JLL for several reasons. First, JLL is cheaper on almost any metric. 2012 consensus values JLL at 13x earnings, while CBG is valued at nearly 14.5x. Many seem to ascribe the valuation differential to the perception that CBG offers more upside leverage due to a more aggressive management team and exposure to the more volatile middle market. While CBG is a more levered equity, and its management targets what appear to be much more aggressive margin targets, we haven’t seen much to suggest that CBG’s earnings should necessarily grow faster than JLL’s. On the other hand, we like JLL’s consistent and well integrated international operations, which should bode well for their ability to land multi-national clients. Industry contacts also have noted that JLL has a much stronger franchise than CBG in East Asian growth markets, particularly mainland China. In addition, JLL ended 2011 with a trailing net debt to EBITDA ratio, including earn-outs, of ~1.5x vs. CBG’s ~2x. While not a dramatic difference, JLL has a bit more balance sheet firepower to take advantage of further market consolidation opportunities. Finally, we like the candor and caution of JLL’s management team. While CBG has a tendency to make over-reaching statements, JLL strikes a consistently measured tone and lays out attainable goals.  

Valuation

JLL is inexpensive at 13x the 2012 consensus earnings estimate. Clearly there is significant skepticism in the market. This is understandable, given that we have only seen the seasonally slow first half, and given the cloudiness of the macro outlook. While near term prognostication is difficult, it is perhaps more interesting to note that JLL’s shares are also reasonably priced based on 2011’s adjusted EPS: under 15x the $4.82 result. As discussed above, JLL was able to generate these earnings on a revenue base that is largely de-risked – we would consider nearly 75% of it to be recurring. In other words, JLL is cheaply priced even if there is a slowdown or pause in the commercial real estate recovery, especially when considering the potential for margin expansion. If we assume that management gets to an EBITDA margin of 13.3%, only halfway to their targeted EBITDA margin of 15%, and if cyclical revenues lines experience low single digit growth rates, we think that JLL can generate 2013 cash earnings per share of ~$7. A multiple of 14x, to reflect the ongoing secular growth opportunity from market consolidation and continued corporate outsourcing of real estate services, would imply a share price of ~$100. If a firmer recovery materializes, and the cyclical lines show growth in the 10% range, higher revenue in concert with additional margin expansion could result in 2013 cash earnings of over $10 per share. Again applying the relatively modest 14x multiple to give credit for secular growth, the implied price of $140 is double the current share price. While these numbers might appear aggressive, note that the share price hit $120 in 2007 with a weaker business composition. Before Eurozone fears in 2011 cast doubt on a steady real estate recovery, the share hit the $105 level. If a 2008-like meltdown were to occur, we estimate that FCF/share would fall to ~$4.00. At a punitive 10x multiple, the downside would be 45%. The upside potential more than compensates for this risk. JLL is an unusually attractive opportunity because it pairs potentially explosive cyclical upside with powerful secular trends. As the commercial real estate services market continues to consolidate, and as penetration of corporate outsourcing continues to expand, JLL’s scale advantages will not just continue to grow, but should accelerate.   

Catalyst

-Continued secular growth in commercial real estate services outsourcing

-Continued market share gains in brokerage businesses

-Faster cyclical rebound in commercial real estate markets