Description

Newmark is one of the world’s largest full-service commercial real estate firms, specializing in tenant and owner leasing representation, property management outsourcing, advisory and capital markets transactions.  CEO Barry Gosin bought the business in 1979 (he’s still only 69 and very active) and built it from NYC focused tenant leasing representation into the leading national enterprise it is today. In addition to core commercial leasing, sales and capital raising, Newmark has a highly profitable agency loan servicing business which I estimate comprises ~25% of profits, but may be underappreciated as it is less than 10% of revenue.

Newmark appears mispriced for several temporary reasons, including:

1) IPO from BGC Partners in Dec17 that may have fallen through the cracks due to quirky ownership structure and high growth in public float from spin-off 11/30/18

2) ~$400m value from NDAQ shares not reflected on balance sheet

3) Improper debt levels cited on major data services due to warehouse loan origination

4) Skewed headline FCF due to warehouse loan origination

5) Incorrect share count levels quoted on major data services

These issues, combined with cyclical concerns associated with commercial real estate and the impact of potentially rising interest rates appear to offer an opportunity to own a well-managed business with ~40% insider ownership and likely favorable secular growth trends at a 40%+ discount to fair value.  Said differently, current valuation reflects a 400-600bps decline in normal EBITDA margins. I estimate the business is worth $12/share, or $13.60 including the value of off-balance sheet NDAQ shares.

Industry overview

There is a good Colliers (CIGI) writeup from 2015 by kerrcap highlighting the secular strengths of commercial real estate, including the opportunity for largest firms to continue bolt-on acquisitions (Big Six have <20% global share), massive addressable market and a generally rational commercial real estate competitive environment. Newmark’s most recent investor presentation also has good industry data. http://s22.q4cdn.com/537561515/files/doc_presentations/2019/03/1Q2019-NMRK-Investor-Presentation-general-IR-PPT-final.pdf

The basic argument of CRE bulls is that the industry is cyclical, but the downturn of 2009 is not the norm, and valuations reflect too high of a probability of a repeat meltdown.  I tend to agree, but we’ll see. The slides in the investor presentation make a decent case.

Going back to Colliers, there are several company-specific parallels between Newmark today and the Colliers story in 2015:

• Recently public

• CEO built the business over decades

• ~40% insider ownership

• Significant growth from acquisitions

I have not found any evidence that Newmark’s business is fundamentally different from its peers to explain its valuation discount.

Newmark overview

Below is a breakdown of revenue by segment, plus a description of how Newmark defines them.  

The company does not disclose profit by segment, but it did $132m revenue in FY18 on a $60B loan portfolio (22bps).  I estimate profit on this business is at least 60% margin (based on WD comp), implying over 25% of cash from operations from this highly predictable revenue stream.  

After servicing, capital markets is the highest margin, but least predictable segment, followed by leasing and outsourcing.

Servicing overview

Despite limited disclosure on this business, publicly traded Walker & Dunlop (WD) offers some insight into its margin profile.

The strong performance of servicing throughout the crisis may be underappreciated since many of these assets were tiny subsidiaries of the megabanks in crisis.  Investors such as Berkshire Hathaway/Leucadia (Berkadia from bankrupt Capmark, 2009) and Ranieri/WL Ross (Berkeley Point from struggling Deutsche Bank, 2011) cheaply acquired valuable servicing operations out of distressed parent companies.

The following excerpt from a trade journal article highlights the business case for Newmark’s Berkeley Point servicing operation and the overall resilience of the model.

The key transaction came in April 2014 when Berkeley Point Capital LLC, a Bethesda, MD-based provider of multifamily financing, was acquired by CCRE (Cantor Commercial Real Estate) [BGC subsidiary]… CCRE, which specialized in commercial mortgage-backed securities (CMBS) and whole loans, didn't have an agency (Fannie, Freddie, FHA) shop, but agency business was Berkeley Point Capital's specialty so the merger of the two companies made sense… The merger also makes sense because clients have made it clear that stand-alone platforms such as those for Fannie Mae, Freddie Mac and FHA loans are viewed as more of a commodity, Day says. "If you don't offer a number of products and services, it's tough to compete. Everyone is far too busy to work with one stand-alone platform at a time."…In addition to the agency work, CCRE picked up the servicing and special servicing business of Berkeley Point Capital. Servicing and special servicing give CCRE a different business model… Post-merger CCRE is a diversified commercial real estate lending platform, focusing on originating, distributing and servicing CMBS, agency, FHA and bridge loans for commercial properties, including most sectors-retail, office, industrial, hospitality and multifamily…

By the early 2000s, Berkshire Mortgage specialized in Fannie Mae, Freddie Mac and FHA multifamily products. Day joined the company in 2001…Then in 2004, German finance giant Deutsche Bank took an interest in the company and acquired it. Berkshire Mortgage became part of Deutsche Bank's global real estate debt markets group.  The new subsidiary was renamed Deutsche Bank Berkshire Mortgage and as it was involved in the government-sponsored enterprise (GSE) business, the company thrived during the recession and early post-recession years, growing from $4 billion to $25 billion in volume from 2007 to 2012. That was all despite problems at the parent company…  "For about a three- to four-year period, the Great Recession curtailed our business," says Day. "We had a head count on employment, couldn't replace anyone who left and couldn't invest in new products and research."  May adds, "While the monoline guys in the agency business survived, most banks pulled out or curtailed commercial real estate lending."  Deutsche Bank subsequently sold Deutsche Bank Berkshire Mortgage.  The major investors were New York based Ranieri Real Estate Partners LLC, founded by Wall Street veteran Lewis Ranieri, and various funds associated with Atlanta-based WL Ross & Co., founded by another real estate financing legend, Wilbur Ross.  The newly independent company was renamed Berkeley Point Capital.

“Bigger is Better” Mortgage Banking; February 2015

Commercial real estate servicing is a much better business than residential due to less staff required, more stable borrowers, negligible prepayment risk, negligible defaults through prior crisis.  Commercial servicing did not witness the disasters experienced by many of the residential servicing firms during and in the years after the US financial crisis.

Below is an overview of Newmark’s publicly traded peers revenue mix--it is one of the few with commercial servicing exposure, which should help earnings predictability through the cycle.

Newmark’s 25% of cash flow from servicing has 8yrs of high visibility, unlike other commercial real estate revenue streams.  This should be an advantage versus many peers.

Possible sources of mispricing

In addition to the relative discount versus peers and advantages of service revenue stream, the following are also potential sources of opportunity at Newmark.

Nasdaq shares

In 2013, BGC sold its eSpeed electronic trading platform to Nasdaq for $750m cash, plus 14.9m NDAQ shares paid ratably over 15 years (2013-2027).  These shares were allocated to NMRK in the IPO. This transfer is contingent upon NDAQ generating $25m revenue, so the receivable is not booked on Newmark’s balance sheet, but the likelihood of receiving is basically 100%.

Newmark executed swap transactions for the 2019-2020 payments ($153m proceeds) and 2021-2022 ($113m proceeds), using the cash to pay down debt.  This gives the company downside certainty, plus upside optionality if the 2019-20 shares exceed the $94.21 strike and the 2021-22 exceed $87.68.

More substantial value exists with the 2023-27 shares, described by NMRK below:

Newmark clearly discloses the Nasdaq shares in its presentations, so they should not be a mystery to anyone following the company, but they do not show up in any screen or to a casual generalist poking around the commercial real estate industry.  At $434m and 268m shares outstanding, ~$1.60/sh Nasdaq value is nearly 20% of current market cap.

Headline debt

Another item which may slip past a casual screen is debt levels.  I nearly passed on researching NMRK because the headline on Factset looks like a highly levered commercial real estate company--no thanks!  

However, most of Newmark’s debt is warehouse loans, which are short-term loans used in GSE transactions and sold within 45 days of funding.  For whatever reason the data services don’t offset these with the associated receivables (or ignore it altogether), but actual net debt is much lower than the headline number.

Not sure how much of an impact this has on valuation, but doubt it helps.  Peers with significant warehouse lending have a similar issue, but seems most pronounced at NMRK.

Headline FCF

The aforementioned warehouse loans also skew FCF calculations with drastic swings in cash from operations due to timing of loan balances.  Before adjusting for this difference, cash from operations is highly volatile. Adjusted for warehouse loans, cash from operations has steadily grown, approaching $300m in FY18.

The optical difference is 11%+ FCF yield versus -15%.  This may make it more difficult for investors to discover NMRK on the merits of its valuation.

Incorrect share count

For some reason, Factset has what appears to be an incorrect share count.  I have no idea why, and the calculation (still wrong) has moved around in recent weeks as shown by screenshots below.  Have asked Factset about it, and their answers did not make any sense.

NMRK has confirmed to me in several conversations that 268m is the diluted share count, and Bloomberg also has the correct number.  Again, not sure if this is the source of mispricing but it does not help.

In addition to the above, the company is still standing up its external facing organization, as it is currently sharing IR resources with BGC.  Newmark is in the process of hiring a new head of IR, which may help improve communication with investors.

Individually, none of these items explain Newmark’s price decline but in combination, it starts to seem more plausible that the business could be overlooked and improperly valued.

Risks

Risks are straightforward, and many of those listed below will eventually occur.  

• Capital markets liquidity evaporates

• General economic downturn

• Drastic change in agency programs.  Most of Berkeley Point’s servicing business is in GSE programs.  If GSEs’ function materially changed and this business went away, this high margin revenue stream would decay over the subsequent ~8yrs.

• Adjusted earnings.  Although Newmark discloses adjustments, there are a lot.  Management has heard investor complaints and reduced the complexity beginning in 2019 but there are still more line items between cash from operations and adjusted EBITDA than is ideal.   

• Growth in share count.  Management uses equity as part of producers’ compensation and as M&A currency.  Share count has steadily grown, forecast +5-7% in FY19.

• Barry Gosin departure.  He has built the business over 40 years and sold to BGC Partners in 2011.  The business has grown very well since then and maintained its reputation in the industry, but the scuttlebutt on controlling shareholder and Chairman Howard Lutnick is mixed.  This is enough of an issue that BGC posted an article about it on its website: https://www.cantor.com/2016/03/23/howard-lutnick-comments-does-bgc-partners-suffer-from-a-lutnick-discount/

Valuation

For the sake of comparability with peers and due to NMRK’s limited trading history, I used EV/EBITDA as a valuation benchmark.  Aside from the crisis, the group has generally traded in a range of ~6-16x EBITDA.

Using a median 11x for Newmark, I assumed a 15% EBITDA margin, which is roughly FY18 EBITDA, excluding several non-cash compensation items the company adds back.

On this basis, shares are worth ~$12 or ~40% upside from $8.50/sh.  The upside is ~60% including the $1.60 from Nasdaq value.

Another way to think of this is pre-Nasdaq implied EBITDA margin is 11%.  Including NDAQ value, implied EBITDA margin is 9%. This 400-600 gap between current levels seems like enough of a cushion that the market is factoring in a healthy dose of macro risk.

Optionality

• International growth.  Almost all revenue today is US (peers 30%+), aside from an alliance with Knight Frank through Dec20.  While the Knight Frank partnership will likely be extended as in the past, management has been very candid about its desire to grow abroad.

• Acquired.  Newmark has an enviable position in major US markets, especially New York.  This could be coveted by a wide range of buyers. Insiders have controlling voting shares, but Chairman Howard Lutnick has demonstrated a willingness to monetize undervalued assets in the past.

• Superior cross-selling.  A big part of Newmark’s growth strategy is cross-sales within the company.  Initiatives such as attaching financing (originating, not funding loans) to transaction advisory are very profitable.  This FY17 “capture rate” was 13% and FY18 was 23%. Newmark estimates peers are closer to 40% and thinks it can get there soon.  This is one example why revenue per producer continues to improve ($905 as of 12/31/18). Upside from current goals would be additive to value.

• Nasdaq shares appreciate.  Minimal value ascribed today but the ~2m FY19/20 shares have upside with NDAQ above $94.21 and ~2m FY21/22 shares above $87.68.  The ~5m 2023-27 shares ultimate value will depend on how NDAQ trades over time.

Catalyst

Nothing in particular.  Maybe normalizing post-spin shareholder base, continued earnings stability.  Factset fixing share count.