Description

Marcus & Millichap (MMI) $24.99

Summary

Marcus & Millichap (MMI) is a national commercial real estate brokerage firm focused on properties in the $1MM - $10MM price range. In addition to brokerage services, MMI also provides financing and research services. MMI has a leading market share in a highly fragmented market and benefits from its national footprint and longstanding customer relationships developed over its 45-year history. The equity has sold off significantly since late 2015 on macro concerns regarding rising interest rates and the real estate cycle. I believe that the macro concerns are overblown – particularly in light of the impact of the UK voting to exit the EU – and MMI’s strong balance sheet, variable cost operating model and experience in operating across several real estate cycles provide substantial downside protection.

Background

Marcus & Millichap is a leading commercial real estate brokerage firm offering sales, financing and research and advisory services. The company focuses on the private client market which it defines as properties trading in the $1MM - $10MM range. Compared to the middle market ($10MM - $20MM) and the institutional market ($20MM+), the private client market is the largest segment characterized by a greater number of transactions and dollar volume and less volatility across the real estate cycle as transactions are often triggered by individual events (death, divorce, partnership breakup, etc.) than by macroeconomic factors.

MMI exhibits a great deal more stability than its competitors given its exposure to a large number of relatively small dollar value transactions across a diverse range of property types and geographies. It’s larger public competitors like CB Richard Ellis (CBG) and Jones Lang LaSalle (JLL) focus on the institutional marketplace characterized by a smaller number of larger transactions which is inherently more volatile and subject to greater correlation to macroeconomic factors.

MMI was founded in 1971 and went public in late 2013. 55% of the stock is owned by Phoenix Investors which represents the interest of the founder, George Marcus (age 75).

The company has 79 offices in the US and Canada. Canada represents 3 offices and around 1% in revenues. MMI has over 1,600 sales and financing agents. The sales agents are independent contractors and 34% have been with the company in excess of 5 years.

The private client market is highly fragmented with the top 10 US brokerage firms having 24% combined market share. MMI is the market leader with 8%, almost twice the share of #2 player CB Richard Ellis. In the highly competitive office segment, MMI ranked third in transactions in 2015 behind CB Richard Ellis and Cushman & Wakefield. In the apartment and retail segments, MMI is the clear leader over CBRE.

MMI has built a defensible market position through its focus on a diverse mix of smaller commercial and specialty properties. A continued market opportunity exists for the firm to increase its penetration in specialty property segments in addition to increasing its market share in established segments and underpenetrated geographies given high industry fragmentation. The average market share in MMI’s top 10 markets is 22% while it’s national market share is 13%

MMI has a financing business that arranges financing for their customers’ transactions. This business represents 6% of revenues, has plenty of headroom to grow, is capital light and does not expose the firm to any credit risk.

The Opportunity

MMI’s equity began a sharp decline in November of 2015 after announcing that transaction financing was taking longer to close in the third quarter of 2015. This combined with fears of rising interest rates fomented the consensus view that the real estate cycle which had risen sharply off the 2009 recession lows was nearing its end. Since June 30, 2015, MMI has underperformed the S&P 500 by 47 percentage points (-46% vs 1% including dividends).

This underperformance was exacerbated in part because of the substantial outperformance of MMI following its IPO in late 2013. MMI had returned 285% from 10/30/13 – 6/30/15 versus a total return of 18% for the S&P 500. The hot money that had bid MMI up to 28x trailing earnings rushed for the exits fearing that the party was about to end and end badly. While MMI’s enterprise value has been halved in the last year, operating metrics have risen 10%, resulting in a very palatable valuation.

On June 24, 2016, financials and real estate related businesses incurred substantial losses in response to the vote by the UK to exit the EU. MMI closed down -5%, CBG was down -9%, JLL was down -12% and HF was down -5%. I believe that in the case of MMI, this knee-jerk reaction is unwarranted.

From a macroeconomic standpoint, MMI is well positioned. It is focused on the US market (Canada represents 1% of revenues) with no direct exposure to foreign real estate markets. The rising rate fears that sparked the initial sell off last fall have been removed from the discussion in the wake of the Brexit vote.

In a persistently low-rate environment, US real estate continues to offer yield and stability to investors. In fact, the spread of commercial real estate capitalization rates to treasuries has expanded with the decline in treasury yields due to global macroeconomic concerns.

The private client market characterized by a large number of small value transactions provides inherent stability. MMI’s highly variable cost business model and fortress balance sheet with $198MM net cash positions the firm exceptionally well in the face of a downturn. In fact, I believe any industry downturn would disproportionally reward a well-capitalized firm like MMI that can use its war chest to expand and consolidate market share.

The initial selloff last October was prompted in part by the revelation that lenders were being more cautious in underwriting which was extending out the closing timelines. MMI has maintained that these conditions have persisted for the last three quarters but that deals aren’t being killed, they’re just taking longer to close. Market tops are not characterized by tightening lending standards. Most investors are so afraid of repeating the mistakes of the last recession that they forget that it’s the things you’re not paying attention to that have the ability to surprise.

There is a predominant belief that because the real estate cycle has been growing for seven years since the last bottom that it must be nearing the end. However, cycles don’t die from old age. The factors that matter most are that a) supply and demand are in balance because job growth has not been offset by rampant overbuilding and b) lending standards have remained prudent. Credit is readily available for good projects, but lenders are still smarting from the last recession that no irrational exuberance is apparent.

The only artificial driver of the real estate cycle is the low interest rate policies of central governments around the world. However artificial, this driver is not likely to diminish in the near term. And I would argue that when it does, the private client market that MMI focuses on is diverse enough to provide stability particularly if MMI can capitalize on the disruption to increase its market share.

The downside protection on MMI is driven by a business model characterized by high variable cost and low capital intensity. Because the business went public in 2013, we do not have financial data for the 39 years of company history that preceded the IPO, but it is safe to deduce that they successfully navigated through a number of challenging market cycle bottoms prior to becoming a publicly traded entity. While data for the 2009 bottom is not available, the company remained profitable in 2010 while it was still shrinking to adapt to changing market conditions.

The number of sales professionals bottomed in 2011 although productivity had already turned upwards by then. The key factors to note in MMI’s business is that at cycle bottoms it can maintain profitability by rapidly shrinking variable costs. Then as the cycle recovers, tremendous operating leverage is unleashed at little capital cost by adding agents and benefiting from increased productivity per agent.

An unlevered company sitting on a pile of currently low-yielding cash that has proven its ability to remain profitable at cycle bottoms and has a 45-year history of navigating through a cyclical industry doesn’t seem as scary as the consensus opinion would indicate.

The Data

Consensus estimates (coverage is from the four banks who were involved in the IPO) are for 8% revenue growth in 2016 and 11% in 2017 resulting in Earnings growth of 4% in 2016 and 14% in 2017. Currently the equity is trading at a depressed 6.8x 2016E EBIT and 6.0x 2017E EBIT. For an unlevered company that can be profitable at the bottom of the cycle and exhibit great operating leverage and earnings power in the upcycle, such a low multiple seems unwarranted.

My base case is that growth continues at a moderate rate as the real estate cycle is protected by the absence of overbuilding and extended by the continuation of low interest rate policies. Lending standards remain prudent but secured credit is still readily available. Revenue growth of 8% in 2016 and EBIT margins down 60bps to 16% in 2016 on continued investment in the business yields an enterprise value of $1.1b at a conservatively re-rated 9x EBIT resulting in a share price of $32, +28% over the current quote. Continued revenue growth and margin expansion plus additional cash on the balance sheet from 2016 operations, could result in share appreciation to $39 in early 2017, 57% above the current quote.

My downside case shows revenue growth slowing down in the remainder of 2016 and 2017, margins slightly compressing and further multiple compression the 6x EBIT. Downside to $22 or -12% below the current quote is possible.

My upside case has modest acceleration in revenue growth and margin expansion and a still conservative re-rating to 10x EBIT. While deal comps are not hard to find, finding detailed financial data on them is. I believe most businesses of this quality (and many of lesser quality would change hands at prices in excess of 2x Revenues to a strategic buyer who could extract synergies. Upside potential to $36 in 2016 and $44 in early 2017 factoring in cash earned in 2016 for upside of 45% and 77%, respectively from the current quote.

With base upside of 28% - 57% and reasonable downside of -12%, MMI offers a highly asymmetric reward to risk ratio in excess of 3:1 and 4-5:1 when incorporating the upside case. I recommend purchase of MMI at current prices and an increased position on price weakness relating to general macroeconomic uncertainty.

My opinion would adversely change if there is evidence of lax lending standards in the commercial real estate market, a sharp decrease in liquidity available to purchasers and/or a sharp decrease in the absorption of new build units indicating an adverse supply/demand imbalance.

Catalyst

Continued operating performance must ultimately result in investors separating the wheat from the chaff resulting in a re-rating for MMI: a growing, capital-light business with high variable costs and experienced managemnet that has demonstrated its ability to remain profitable at the bottom of the cycle while retaining tremendous operating leverage as the cycle expands. MMI is a healthy baby being thrown out with the bathwater on macroeconomic fears that even if proven true, will not impact all companies equally. With limited downside and significant upside potential, MMI offers a highly assymmetric reward-to-risk profile for the conservative investor.