LSL Property Services PLC (LSL) is a leading real estate services provider in the United Kingdom that boasts a strong cash-generating franchise, returns on equity in the 25-30% range, solid balance sheet, and management team with an exceptional track record of creating shareholder value.  At same time the company’s stock is selling at a very attractive price of approximately 8X NFY EPS and sports a 4% dividend yield.

LSL comprises a residential property surveying business (akin to a property appraisal business in the United States) and a real estate agency business.  LSL has a #1 position in the property surveying business and a #2 position in the real estate agency business in the United Kingdom.  In normal times the surveying business contributes about 40% of EBIT, with the remaining 60% coming from the estate agency business.

LSL’s surveying business is a fairly stable cash generator, primarily because of the structure of the surveying industry in the United Kingdom.  British banks typically outsource management of the surveying operation to a third party called panel manager (such as LSL), which has a degree of discretion over work allocation.  For example, when the market is strong the panel manager may allocate more work to outside surveyors, whereas when the market is soft the panel manager may bring more jobs in-house so that the overall volume of work performed by the panel manager is relatively unaffected.  LSL has a very strong competitive position in the surveying market, as banks prefer to deal with reputable panel managers who provide services in an efficient and reliable manner.  It makes little sense for a bank to risk disrupting its lending process in order to save a small amount of money (surveying cost represents approximately 1/10^th of 1% of the average mortgage) by teaming up with an unknown panel manager.  In addition, LSL generates a significant amount of business for the banks through its estate agency (i.e. mortgage referrals), further incentivizing the banks to team up with LSL on surveying.  Case in point: when the financial markets crumbled in 2008-2009 LSL surveying division was able to gain significant market share due to its superior reputation.

LSL real estate agency, which includes the country’s leading brands such as YourMove, Reed Rains, and Marsh & Parsons, provides exchange services, and also lettings and asset management services.  LSL’s estate business has a solid competitive position in the UK, as evidenced by the company’s ability to charge commissions of approximately 1.5-2% vs. 1% that are typical for smaller independent estate agencies.  It is likely that LSL will experience significant growth in its estate agency business going forward, as this is a highly fragmented industry in which the top three players comprise less than 20% of the market.

Strong competitive position across its business segments enables LSL to generate returns on equity in the 25-30% range while employing little debt (less than two year debt payback as of FY2011) even in the toughest real estate market that the UK has seen in decades.  To put things in perspective, there were about 550,000 exchange transactions in the UK in 2011 compared to a 10-year average of 1.2 million transactions.  As the real estate market recovers LSL should be able to generate even higher returns in its business.

An additional – and significant – advantage that LSL has over its rivals is the company’s top-notch management team.

LSL’s management has a great track record in growing shareholder value since the MBO that took place in 2004 despite having to navigate through the worst housing market in the UK in decades.  Over time LSL significantly increased its market share in surveying and estate agency both organically and through acquisitions, substantially reduced its cost base, and expanded its service offerings.  A good example of the managerial skill of LSL’s executives is a 2009 acquisition of Bank of Scotland’s real estate agency business.  Under the terms of the transaction, LSL was paid a substantial sum of money (equal to about 20% of revenues of the acquired business) to purchase a major U.K. real estate agency (the agency would be immediately profitable even under the weak market conditions after eliminating former parent’s corporate cost allocations).

Further, LSL management’s interests are aligned with those of shareholders as the top three executives own about 15% of the company, while cash compensation is fairly modest.

VALUATION

Based on the current market conditions reflecting the worst housing market in decades LSL appears attractively priced at 8X NFY EPS and a 4% dividend yield.  However, the above valuation is based on the current state of the UK housing market that is going through the worst downturn in decades.  Adjusting the company’s EPS to a figure more reflective of the long-run average of housing transactions, results in NFY PE of about 5X.  Whichever way you slice it, given the economic characteristics of LSL’s business the stock is significantly underpriced.