LSL Property Services (LSL.LN) is a BUY with +75% upside.  The company was previously written up on VIC in Jan 2012 and the stock has since performed well (+58%).  Recently, LSL has fallen 22% from it’s 52 week high as concerns over the mortgage market review may delay the UK housing recovery.  While this very well be the case, I think LSL offers significant upside to investors due to:

1)      Though shares trade at just 13x 2014e EPS, 2014 UK residential housing transactions are expected to be 32% below their long-term (30 year) average.  A rebound to normality will drive strong revenue growth through 2017.

2)      There is significant operating leverage in the business.  Unlike in the US, less than 50% of estate agent compensation in the UK is variable – as such, operating margins will expand meaningfully as a rebound in housing market transactions drive revenue higher.  Management estimates that incremental operating margins in the estate agency business are ~40%.  As such, operating margins in the Estate Agency business (which represented 2/3 of 2013 group operating profit) should increase from 15% in 2013 to 23% (at 1.2 million transactions – assumed to be reached in 2016).  In a very strong market (if transaction levels ‘overshoot’ as the market catches up for 7 years of very low transaction levels), OPMs could approach 27-28%. 

3)      A wind down of PI claims + solid balance sheet + Strong cash generation coupled with IPO of #2 property website Zoopla (LSL sold ½ of it’s 4.9% stake at the IPO and announced these proceeds will be returned to shareholders via a dividend).  There an opportunity for increased cash returns to shareholders over the next 24 months.  The business requires very little incremental capital to grow and acquisitions are likely to be small.  I suspect LSL may return up to an additional 20% of it’s market cap to shareholders in the form of a special dividend (liquidity likely prevents a buyback) over the next two years.

4)      After demonstrating an ability to earn high levels of profitability in a tough market (LSL’s estate agency business earned an 11% operating margin in 2012 at transaction levels 50% below normal) due to tight cost control and increased mix of counter-cyclical operating income (repossessions business + lettings represented 33% of 2013 estate agency revenue), LSL should garner a 15-16x P/E multiple (my valuation is based on 15x NOPAT multiple).

5)      There is potential upside in the surveying business as 40% of the business is up for tender this year (operate under 2-5 year contracts with lenders).  Unlike the last time LSL re-negotiated these contracts in 2010-2012, volume is improving and the market is short surveyors.  Furthermore, market share has balanced out (LSL had an artificially high market share in 2010 owing to Countrywide’s bankruptcy) and pricing is more rational.  Pricing had been soft when the last contracts were renewed due to 1) soft market and (2) Countrywide emerged from bankruptcy and was looking to reclaim some market share driving down prices.  Market share between the top three companies has stabilized (top 3 – LSL, Connell’s, and Countrywide represent 90% Management expects a pricing improvement as these contracts are re-tendered.  This could drive revenue incrementally higher than forecast (I’ve only assumed volume increases) and bring OPMs back to 27-28%. 

Background

LSL is the #2 estate agency (behind Countrywide, ticker CWD.LN) operating 400 company owned branches (90% of which are outside the London area and geared for a greater rebound in transactions – prices outside London, while not cheap are less likely to be materially overvalued) and the leading surveying business (property appraisals where it has about 33% market share).  Over the past 5 years the company has transformed itself from being heavily reliant on it’s surveying business, due to having it’s estate agency business represent over 2/3 of operating profit in 2013 (despite transaction levels being 40% below normal).  This was accomplished under it’s past management team lead by Simon Embley (now Deputy Chairman – still owns nearly 6% of shares).  On an adjusted basis, LSL earned as much in 2013 (again w/ tnx levels 40% below normal) as it did in 2007 (which was above normal).  As the market rebounds we are likely to see a marked improvement in profitability.

Forecast/ Valuation

As you can see, I’m assuming that LSL’s exchange income (commissions from home sales) grows in-line with overall UK housing market transactions volumes.  Realistically we can expect another 2-3% pa from higher home values (assuming values grow in-line with household income).  Financial service income (selling mortgages and insurance) is linked to transactions and assumed to grow at the same rate whereas lettings growth will see a deceleration in growth. 

The key to the investment case is operating leverage – unlike the US where agent commissions would eat up most revenue growth, in the UK, agent compensation is less than 50% variable which allows for significant operating leverage as the housing market rebounds. 

I assume that the survey business grows in-line with transactions and that LSL maintains it’s current market share.  OPMs should benefit as pricing improves given a relatively tight market situation and contracts coming up for renewal in a more favorable pricing environment. 

The professional indemnity (PI) claims refer to claims against LSL for appraisals from 2005-2008 where valuations proved to be too high.  This was an industrywide issue (Countrywide took charges in 2011-2012).  I provisions are increased 20% - given that house prices has improved over the past year (potentially negating some of the damages), this is likely unnecessary.  A +/- L10 mn swing shouldn’t impact the valuation much.

RISKS

-        Management transition – last year Simon Embley (remains deputy CEO and 6% owner) stepped down as CEO.  Simon lead the LBO in 2001 and was a great CEO.  I have not met his replacement Ian Crabb but hear he seems competent.  Even if he is above average, this is a downgrade in management in my view.

-        Mortgage market review – It is unclear how much the review/new guidelines will impact the market though we’ve seen mortgage approvals trend down in the last month or two (some of which could be temporary as bankers make adjustments).  I take a 4-5 year horizon in investing and assume the market reverts back to it’s long term average by 2017.