|Shares Out. (in M):||106||P/E||10||9|
|Market Cap (in $M):||526||P/FCF||9.7||9|
|Net Debt (in $M):||-60||EBIT||50||58|
|TEV (in $M):||466||TEV/EBIT||6.5||5|
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LSL Property Services PLC - Thesis Overview
LSL Property Services PLC (“LSL” or “the Company”) is a leading provider of services linked to UK housing and mortgage transactions, principally mortgage and non-life insurance brokerage, residential property surveys, and real estate agency services. Operating profit by division is 39% Surveying, 34% Financial Services, and 27% Estate Agency, based on our 2022 estimates. While LSL historically was highly exposed to housing market cyclicality, direct housing cycle exposure now totals just 25% of revenue. LSL today is principally driven by the less cyclical mortgage (UK consumers generally refinance every 2-5 years), insurance, and property rental markets. In fact, management expects to deliver YoY earnings growth in 2022 despite a ~20% decline in UK housing transactions. We believe the current valuation fails to reflect LSL’s continued transformation – Just 8x the house broker’s 2022 NOPAT estimate. We expect the stock to re-rate as (1) LSL’s upgraded management team drives growth in the Financial Services Network (pure-play peer Mortgage Advice Bureau’s trailing five-year average NTM NOPAT multiple is 21x), (2) other Financial Services initiatives come to fruition (most notably a recently formed JV with private equity to consolidate the fragmented mortgage broker space led by LSL’s founder and 6.5% shareholder Simon Embley), and (3) continued improvement in investor communication to highlight Financial Services translates to a better understanding of “new” LSL among the investment community. Simon’s involvement as CEO of the JV and LSL board member excites us, as we believe he is laser focused on realizing shareholder value as quickly as possible.
Financial Services Network
Based on our research, LSL’s current valuation fails to reflect the value of its assets and in particular its gem asset: Financial Services Network (the “Network”). LSL’s Financial Services segment is broken down into two sub-segments: Financial Services Network and Financial Services Other. The Network contributes >30% of LSL’s operating profit and serves as a middleman between UK lenders and insurers and the independent mortgage and insurance brokers who distribute products to consumers. Known as an intermediary network, the Network provides nearly 1,000 independent firms with access to a broad panel of mortgage and non-investment insurance products, compliance infrastructure to ensure adherence with Financial Conduct Authority (FCA) regulations, business development support, and its proprietary end-to-end customer service platform called Toolbox. With member firms averaging just ~2.5 brokers in size, the Network allows them to leverage benefits of scale: access to more products at better commission rates due to LSL’s negotiating power, more robust compliance infrastructure and procedures, and more efficient customer service due to LSL’s continued investment in the Toolbox platform. In exchange, the Network charges fees to cover its fixed costs and retains between 10-15% of a broker’s commissions, with the balance passed on to the broker. This highly scalable model is growing revenue organically at double digit rates, primarily driven by adding additional brokers to the platform. Management is targeting 200-400 net adds per annum into the medium term, which we view as credible given the fragmented nature of the market (LSL is the #1 with ~10% share) and the benefits available to small firms from joining a scaled intermediary network. The Network is currently earning ~50% incremental margins while investing through the P&L, with higher incremental margins achievable as investment spending rolls off. With brokers generally requiring 6-9 months to achieve steady state productivity after joining the Network, each broker add also creates latent earnings power not obvious to investors.
We believe LSL’s Financial Services Network can structurally increase its market share over time as (1) independent mortgage brokers account for an increasing share of mortgage volumes as lenders rely more on 3rd parties for distribution and (2) small mortgage brokerage firms that are currently directly regulated by the FCA increasingly move to scaled intermediary networks. Since the Mortgage Market Review introduced in April 2014 by the FCA, UK lenders must ensure that all employed mortgage professionals are qualified to provide advice to consumers on their mortgage choice rather than simply providing information. In response to increased training and compliance costs, many lenders responded by reducing the number of employed mortgage advisers, with some choosing to offer mortgages exclusively through independent brokers. Due to lender retrenchment, total intermediary share of mortgage volumes increased from 60% of lending in 2014 to 80% in 2020 (market size excludes product transfers – where a borrower refinances with their existing lender). We expect intermediary market share will continue to grow as UK lenders continue to structurally reduce the size of their bank branch networks and the number of employed mortgage advisers. By outsourcing distribution to independent brokers, lenders benefit from a more variable cost structure, as commissions are only paid to brokers if a mortgage is originated. In addition, the UK’s ~16.5-17k independent mortgage brokers continue to be split ~50/50 between firms in intermediary networks such as LSL and firms that are directly regulated by the FCA. Notably, the average firm in the marketplace has just <3.5 brokers, with nearly 90% of firms having 5 brokers or fewer. Given the cost of compliance is expected to increase in the coming years driven by closer FCA oversight of small firms, the business case for joining a scaled intermediary network should become increasingly attractive for a significant portion of firms that remain directly regulated today. With LSL’s Financial Services Network and its principal intermediary network peer Mortgage Advice Bureau (MAB) together possessing just <20% market share, the runway for market share growth appears compelling.
The valuation gap between LSL and MAB highlights the current mispricing, in our view. LSL’s Financial Services Network is highly comparable to the pure-play MAB, which currently trades for 21x 2022E adjusted EBIT on the house broker’s (Numis) estimates and historically traded for 17.5x NTM EBIT on a trailing five-year average basis. Similar models in other markets, such as Steadfast and PSC Insurance in Australia and JDC Group in Germany, also trade for comparable multiples. Ascribing 17.5x EBIT to our 2022 estimate for Financial Services Network EBIT implies the market is valuing the rest of LSL’s operation, which currently produce £30m in EBIT after unallocated overhead, at effectively 1x EBIT.
Beyond the Network, we believe the Company’s Financial Services Other, Surveying, Marsh & Parsons, and Franchise Income assets have material value. Surveying provides valuations to lenders as support for purchase and refinancing on a multi-year contracted basis, operates in an effective duopoly, and earns >£20m in EBIT before unallocated overhead with negligible tangible capital requirements. Marsh & Parsons is a London-focused real estate agent (average house price ~£900k) with a strong track record of market share growth and the potential to earn >£8m in EBIT assuming a London residential real estate recovery. Financial Services Other provides mortgage and insurance advice to consumers via LSL’s ~400 directly employed brokers and is underearning currently as it ramps up servicing a sizable 3rd party lead source contract. Franchise Income is a high margin, annuity-like revenue stream (totaled nearly £3m in 2021) derived from LSL’s ~130 franchised branches; franchisees pay LSL a high single digit percentage of revenue for the right to use LSL’s brands names, access to its branch operating system, and compliance support
Why is UK Mortgage Brokerage an Interesting Business Model?
While the public US non-bank originators, including Rocket Mortgage, LoanDepot, and Finance of America trade for <8x NTM earnings, we believe UK mortgage brokers are structurally better businesses due largely to two key advantages: (1) more predictable refinancing cycles in the UK underpins superior earnings visibility and (2) simpler income statement and balance sheet profiles.
UK vs. US Mortgage Market
Unlike in the US, where the 30-year fixed rate mortgage is ubiquitous due to Federal Housing Administration policies and the Government Sponsored Enterprises of Fannie Mae and Freddie Mac, ~90% of mortgage lending in the UK is structured to include an initial fixed-rate period totaling 2-5 years, with the rate paid by borrowers resetting to a usually higher standard variable rate tied to the Bank of England’s base rate for the remainder of the mortgage term after fixed rate cessation (The most common mortgage term in the UK is 25 years). For example, HSBC currently offers a 60% LTV 2-year fixed mortgage at an initial fixed interest rate of 2.49%, followed by a variable rate of 3.79%. After the fixed period ends, borrowers will frequently refinance their mortgage once the tie-in period ends (on a 2-year fixed mortgage deal, this may be 3 years), thus allowing borrowers to capture the monthly payment benefit of the 2-5 year fixed initial rate and avoid an early repayment charge. As a result, UK borrowers generally refinance their mortgage on a more regular basis than their US counterparts. This dynamic reduces variability in refinancing activity, which in the US has historically seen between 90%+ YoY growth and 40-50% YoY declines in refinancing volume on an annual basis, driven by the number of borrowers in the money to refinance at lower rates.
UK Mortgage Brokerage vs. US Non-Bank Retail Originators
Beyond the more recurring nature of refinancing activity, independent mortgage brokers in the UK do not originate mortgages via their own balance sheet with the intent to sell the loans in the secondary market. The UK mortgage broker business model is a fee for service model, with a broker earning a fixed commission (typically 35-40 bps) on the value of mortgages originated by lenders for which the broker serve as an intermediary. This contrasts with the US non-bank retail originators, who underwrite mortgages, typically funded with loan funding facilities and lines of credit, then sell them to the GSEs or into the secondary mortgage market. Upon sale, they recognize a gain on sale driven by spreads between the primary market pricing and secondary market demand for mortgages.
Management and Strategy
LSL has shown industry leading execution relative to peers since its IPO in 2006, and we believe the current CEO David Stewart is the right leader for the Company today given his track record of success building and managing financial services businesses in the UK. David was a longstanding non-executive director at LSL prior to his appointment as CEO in May 2020 and was handpicked to lead the Company by the founder Simon Embley for his Financial Services expertise. With a highly capable CEO in place, we believe the path to continued value creation via growth in Financial Services is increasingly clear. Management’s comments and capital allocation decisions since David’s appointment evidence a commitment to bringing Financial Services to the forefront at LSL. Recent guidance indicates Financial Services will surpass Surveying as the largest profit contributor to LSL for the first time in 2023, and we believe the division should contribute >50% of operating profit in the medium term.
Simon continues to play a key role in value creation at the Company, having previously founded LSL in July 2004 via the management buyout of Your Move and e.surv Chartered Surveyors from Aviva. Today he is a board member at LSL and CEO of Pivotal Growth, the JV between LSL and its private mortgage partner, Pollen Street Capital, that is rolling up independent mortgage brokers in the UK. We view Simon’s recent choice to step down as LSL’s chairman to spearhead execution of this buy and build JV as evidence of his excitement about the opportunity to consolidate the highly fragmented mortgage brokerage space. Based on our conversations with Pollen Street, they are delighted to have Simon at the helm. Simon is highly incentivised to create value with the JV via both his direct ownership stake and options exercisable contingent on achievement of return hurdles. LSL and Pollen Street each own 48% of the JV, with Simon owning the balance. LSL benefits from Pivotal Growth in two ways: (1) The value creation from executing the buy and build strategy, for which the company has articulated a 3–6-year time horizon to exit and (2) Pivotal Growth brokers joining LSL’s Financial Services Network in lieu of Pivotal building its own compliance infrastructure; we expect Pivotal’s brokers will remain on the intermediary network even after an exit.
Cash Generation and Inflation Protection
LSL’s business model is highly cash generative given its limited capex requirements (~2% of sales) and negative working capital profile. As such, earnings convert to free cash flow at high rates, and we expect ~100% conversion in 2022-2025. The Company’s earnings stream also possesses a degree of inflation protection, as the commission it earns on house and mortgage transactions is based on a percentage of the transaction value. To illustrate, LSL’s fee for housing sales ranges from 1-2% of the house sale price and commissions paid by mortgage lenders is typically 35-40 bps of the mortgage value.
Balance Sheet Optionality
LSL’s balance sheet is in the best shape since its IPO. Operating cash generation coupled with non-core asset sales in 2021 allowed LSL to pay down all gross debt, leaving the Company with net cash of £45.5m at 2021 end after accounting for £3m of contingent consideration. In addition, LSL possesses £7.4m of financial assets, including equity investments in private companies and its stake in Pivotal Growth. The board sensibly rebased the dividend policy in April 2021 to target a 30% payout ratio, which positions LSL to be more opportunistic in deploying its cash flow. We believe value creation could be accelerated if management were to execute share buybacks at current levels or Financial Services acquisitions. Assuming LSL deployed its net cash balance to buybacks, the Company could repurchase >10% of fully diluted shares outstanding at the current price before tapping its credit facility.
LSL is highly mispriced in our view, as the equity is valued at undemanding multiples against reasonable 2022 and 2023 estimates and a large discount to our 2023 sum-of-the-parts (SOTP) estimate.
The stock currently trades for just 6.5x EBIT and 8x NOPAT on the house broker’s (Numis) 2022 estimates. With Numis assuming reversion this year to the more normalized end market conditions seen in 2019, in-line with management’s expectations, we are comfortable using their estimates. Despite a materially weaker end market (19% YoY decline in housing transactions and 11% YoY decline in mortgage lending), Numis expects LSL to show earnings growth in 2022 driven by Financial Services. This forecast illustrates the limited impact housing market cyclicality now has on LSL’s earnings stream. Looking out to 2023 estimates, multiples compress to 5x EBIT and 7x NOPAT principally due to the combination of growth in the Financial Services segment plus cash generation shrinking the enterprise value. Given LSL’s improved business mix versus its history, we would argue the stock should in turn trade at a premium to its historical valuation. Even if we ascribe a conservative 12x multiple to 2023E NOPAT, in-line with LSL’s own history, this corresponds to a value per share of £6.23 including interim dividends and non-core assets, or 64% upside from the current price.
Given our point of view on Simon Embley’s commitment to realizing shareholder value, we believe a SOTP analysis is reasonable for framing the potential value of LSL in a breakup scenario. Our 2023 SOTP estimate reflects our internal forecast of EBIT by sub-segment, which collectively aligns with Numis’ 2023 EBIT estimate. Based on our conversations with management, the Financial Services Network and Marsh & Parsons businesses operate independent of the rest of LSL and could be separated easily from the group. Regional Estate Agency and Financial Services Other are linked, as Estate Agency serves as the principal source of leads for Financial Services Other. The two assets could be separated if LSL were to execute a lead servicing agreement that would allow Financial Services to operate independently while continuing to service leads from Estate Agency in exchange for an introducer’s fee. Given LSL already executes such an agreement on an inter-company basis, we believe the groundwork is already in place for an eventual separation.
Our SOTP value per share of £7.58 corresponds to 100% upside. Coupling LSL’s clean balance sheet with the cash generative nature of the model and value of its assets in a breakup scenario, we believe LSL is likely to see interest from private equity if the stock does not re-rate higher in the public market.
The table above reflects the following key valuation assumptions:
Financial Services Network is valued at 16x EBIT, a ~10% discount to Mortgage Advice Bureau’s trailing five-year average forward EBIT multiple of 17.5x.
Financial Services Other is valued at 12x EBIT, the 2022E EBIT multiple Mortgage Advice Bureau paid to acquire Fluent Money, a mortgage and specialist lending brokerage firm with a similar model of directly employing brokers.
Surveying is valued at 11x EBIT or 14.5x NOPAT assuming a 23% tax rate. This multiple seems fair given the characteristics noted above (revenue visibility provided via multi-year contracts, duopoly industry structure, highly cash generative owing to limited cash requirements), but these positives are offset by industry cyclicality due to housing transactions exposure and customer concentration with UK lenders.
Marsh & Parsons Estate Agency is valued at 10x EBIT or 13x NOPAT. The earnings stream is underpinned by recurring revenue on property rentals and M&P has a history of market share growth in its catchment areas driven by strong local management. Earnings can more than double from our 2023 estimates in the event the London housing market recovers to pre-Brexit vote conditions seen in 2013-2015, implying ~5x peak EBIT which seems fair given the inherent cyclicality of the real estate agent model.
Regional Estate Agency is valued at 9x EBIT or 12x NOPAT on underlying assumptions that reflect mid-cycle housing market conditions, with assumed housing transactions in-line with the UK’s long-term average. Like Marsh & Parsons, this business is underpinned by recurring revenue on property rentals and is taking market share in its local catchment areas. In addition, Regional EA generates high margin revenue from franchise fees and valuable leads for mortgage and protection products from consumers with high intent to transact (high quality lead sources generally paid 20-30% of a broker’s commission as introducer fee). These positives are offset by the highly competitive nature of the industry and exposure to cyclical housing market conditions.
LSL’s stake in Pivotal Growth is valued at 12x EBIT, in-line with Financial Services Other, net of debt employed to finance acquisitions of mortgage brokerage firms. Assuming strong execution by Pivotal Growth management, this stake could prove to be worth multiples of our base case SOTP, thus presenting a potential driver of mid-term upside for LSL shareholders.
We view LSL’s 48% stake in the Pivotal Growth joint venture as a source of interesting optionality. This JV brings together LSL’s operating expertise in mortgage and insurance brokerage with Pollen Street’s industry roll up and capital markets expertise to drive value creation commensurate with private equity expectations over a 3–6-year investment horizon. With this JV, LSL management demonstrated both creativity in sourcing compelling capital allocation opportunities and a willingness to be held accountable by a sophisticated financial partner. LSL and Pollen Street plan to deploy up to £200m of capital; the two partners will contribute up to £100m, with the balance to be funded with 3rd party debt.
Pollen Street brings a track record of successful execution on brokerage roll ups in markets adjacent to consumer mortgage and insurance, most notably in commercial insurance, where it leveraged the acquisition of Miles Smith in 2018 to create a specialist commercial insurance brokerage platform called Specialist Risk Group (SRG). SRG was sold in early 2021 to a generalist US-based private equity firm, with the exit returning multiples of Pollen Street’s invested capital. The playbook for Pivotal Growth shows parallels to SRG: Layer in mortgage broker firms at reasonable implied multiples, leverage LSL’s Financial Services Platform to reduce operating costs, drive organic growth via productivity improvements, and then market Pivotal Growth as a scaled platform to command a higher exit multiple.
While the JV is difficult to underwrite given it remains in the early innings of execution, the sensitivity below illustrates the prospective contribution to per share value at LSL under a range of scenarios. For the purposes of this exercise, we have assumed up to £200m is deployed by 2022 end with an exit in 2023 capitalized at up to 17x calendar 2023 EBIT. Assuming £150m is deployed by the end of 2022 at a blended 11x entry EBIT multiple, with the enterprise valued at 15x 2023 EBIT, this scenario would result in >60p per share of value and a doubling of LSL’s invested capital.
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