Description

CJAD provided a thoughtful write up on Realogy as a long in late September.  We respectfully take the other side and submit the idea now as a short

Summary

We are recommending Realogy Holdings (RLGY) as a SHORT with a 12/21 price target of $12 (9x ‘22E EPS of $1.34) for a total return of -25% compared to today’s share price of $18 (this return is net of dividends and includes shrinking the share count 8% through buybacks).

We expect the Company’s operating challenges to continue, if not accelerate, as they face a combination of technological and secular pressures alongside heightened competition and an eroded value proposition. To put the Company’s recent trajectory and weakness into perspective, EBITDA is down from 2013 to 2018 (despite acquisitions) while RE transaction volumes in the US are up nearly 30%.

We are underwriting EBITDA declines of -8.8% per annum through 2021 (roughly -14% below consensus in 2020) as margins decline from 11.5% today to 8.0% (continuing the 160 bps margin compression since 2015). These declines are exacerbated by the Company’s significant leverage burden (~5.0x using non-covenant defined EBITDA) which should contribute to a ~20% decline in EPS despite the benefit of interim share repurchases.

In short, we believe Realogy will follow a similar path to Countrywide Plc in the UK who was caught flat footed by technology trends and new competition and saw their share price decline more than 90% over three years once their market share began to erode. If that precedent proves correct the downside for the shares would be dramatically greater than what’s outlined above.

Business Description

Realogy (RLGY) is the leading provider of residential real estate services in the US with more than 289k independent sales agents worldwide (including 50k company owned agents) with approx. 15k offices (790 company owned) worldwide in 116 countries and 6,100 brokerage offices in the US. RLGY’s businesses are broken down into four segments:

Real Estate Franchise Services (“RFG”): RLGY provides technology and support services along with a well-known brand name to third party owned brokerages (including NRT) in exchange for a franchise fee. Key brands include Century 21, Coldwell Banker, ERA, Sotheby’s, and Better Homes & Gardens. Unlike NRT, the RFG group is more evenly located throughout the country with an average sale price ~$285k. RFG is involved in 21% of transactions nationwide and accounts for 8% of revenues and 27% of EBITDA.

Company Owned Real Estate Brokerage Services: (“NRT”): RLG operates its own brokerages under the Coldwell Banker, Sotheby’s, Corcoran and Citi Habitats brand names. NRT is heavily focused on the coasts in major metro markets, including NY, CA, Florida, and Texas (>60% of sales.)  NRT generally caters to the high end of the real estate market with an average sale price >$500k (almost 2x the country average) and ~20% of homes sold >$2.5m in value. NRT is involved in 3% of transactions nationwide and accounts for 75% of revenue and 59% of EBITDA

Cartus: Provides corporate relocation services to more than 54% of the Fortune 50 corporations and helps generate leads for RFG and NRT.

TRG: Provides title and settlement services to both RLGY and third party brokers and customers.

Market Size and Fundamentals

RLGY estimates that more than $70Bn in gross commission income was generated in the US in 2017 of which the Company’s owned brokerages and franchisees earned approximately $13Bn or 19%. Approx. 88% of home sales used an agent or broker and the average annual commission rate nationwide is 5.1%. Home prices have CAGR’ed at 4.1% from 1971 to 2017 and transaction volume has grown 7.2% annually over that period.

Investment Thesis

A combination of secular and technological pressures are driving reductions in franchise royalty rates and sustained increases in commission rates paid to agents.

These two phenomena are driven by separate trends:

1)     Technology and social media have disintermediated the traditional broker/agent relationship. Agents are now building their own brands online (via Instagram accounts and Facebook pages) while also developing expertise in online lead generation via Zillow. Upstart brokerages like Keller Williams/Compass have leveraged these trends and are competing for the most productive agents by reducing splits. Moreover, high-end agents (more associated with NRT biz) are leveraging BPO tools to run larger teams further increasing their scale and negotiating leverage. We believe RLGY is facing a long-term secular headwind as their commission splits trends towards that of the market average of 85/15 (see below from Real Trends) vs. their low 70s today.

2)     Franchise royalty rates are declining as independent brokers/agents have had to innovate independent of the mothership and are taking on more costs than ever before (including technology and their own sales and marketing). This is providing them more leverage over pricing while agreements are shortening so franchises are more often exploring a switch to another company, driving down rates.  Here too the power of Zillow and Social Media means that franchises can own their brand now like they hadn’t in the past. As a result the business risks of switching to another franchise are perceived as less severe.

Sell side analysts (and our own internal forecasts) have consistently underestimated these pressures and assumed they would eventually level off or steady.

Instead, the pace of declines have accelerated yet the sell side continues to forecast a stabilization. Our conversations with industry experts suggest these trends should continue as the costs to an independent brokerage continue to increase while the switching costs decline. We also expect the total number of brokerages/agents will decline putting additional fee pressure on those that want to retain franchisors. Moreover, disruptive tech-first firms like Reside and eXp Realty are automating back office processes via technology (ie adding value and lowering costs), providing better value to the franchisor (besides just textbook and brand) for more attractive splits.

Topline growth decelerating given prolonged recovery of US housing market and exposure to CA/NY -– providing more risk to downside than upside

The US housing market has staged a tremendous rebound since 2008 but existing home sides have begun to decelerate, growing just 1.3% YoY in 1Q18, -2.3% in Q2, and -2.6% in Q3. RLGY’s RFG market share has declined from a high of 10.7% in 4Q15 to 10.2% today (with NRT flat over that period). Average home sale price has remained strong, growing MSD over 2017 but we expect that to taper off, particularly in the Company’s NRT business given its 50% exposure to NYC and CA both highly impacted by the removal of SALT deductions and subsequent outflows. In fact, closed sales declined 11% yoy and median price declined 5% yoy in Manhattan in Q3’18.

Operating (deleveraging) and heavy fixed cost base should augment downside and erode margins – similar to that of Countrywide in the UK

RLGY cut nearly $550MM of costs during the downturn (converting print marketing to online, exiting unprofitable businesses, reducing office count by 33% etc.) of which $400m was in permanent fixed costs. With that in mind and given the low margin profile of the business and rising technology and marketing costs, we believe the Company has limited room to combat the aforementioned pricing pressures.

Moreover, these pressures (particularly those on the RFG business) fall exclusively to the bottom line. RFG EBITDA margin has declined from 4.6% in 2015 to 2.7% in 2018 leaving minimal room as splits continue to grow. NRT margins remain robust in the high 60s but we expect those to turn as the Company fends off competition and/or faces declining commission rates.

For perspective, Countrywide Plc, a UK high street brokerage saw their market share drop 160 bps to 4.5% between 2014 and 2017 but saw EBITDA margins decline from 17.2% to 9.6% over that period as they rolled out new product offerings with worse pricing structures and invested in technology to compete with disruptive entrants. Sales were down just -5% but average EBITDA per transaction dropped -27%. The Company’s leverage ratios increased (from <1.0x to 3.0x) which caused them to raise equity further hurting the multiple and share price which subsequently declined from GBP300 to GBP10 today.

Our view is RLGY is in the early stages of a similar transition as the Company has yet to really face any product (read: pricing) innovation nor any market share losses. RLGY’s capital structure is also more levered than Countrywide’s with net debt to EBITDA at 4-5x. They’ve been protected thus far by tax reform (tax rate dropped 11%) and refinancing their debt which should save nearly $10MM per quarter but their opportunity set is limited moving forward. In the meantime, the Company is focused on share buybacks to juice EPS growth which magnifies the erosion of the underlying business over the long run.

Risks

New management and focus – Realogy hired the former President of Capital One’s card division to join as CEO at the end of 2017 who has placed a renewed emphasis on reducing commission pressures and restructuring costs. Management has noted new technology products to help improve agency efficiency and continues to trumpet its data advantage to improve target recruitment and enhance its value proposition. Our view is the former CEO, who was at the helm for the past 10 years, chose an opportune time to retire given the growing headwinds facing the business and the CFO just recently did the same after 15 years with the Company

Accelerated capital return to shareholders – management announced an additional $350MM share buyback program in February 2018 which will be their capital allocation strategy moving forward vs. M&A. By the end of the year the Company expects to have spent $400M on share repurchases (18% of the current market cap).  We believe this is a risky strategy in light of their large debt burden and also expect the pace should decelerate meaningfully going forward as the impact of higher leverage sets in.

Cheap FCF yield – RLGY stock is ostensibly cheap on a FCF basis at a 10% yield although we do not forecast any FCF growth from here. We are buoyed by the fact that we are below consensus on nearly all of our numbers (and that consensus has repeatedly been wrong over past few years)

Catalyst

• Splits continue to be renegotiated as they're renewed. This will be important to watch as RLGY announced they're "rationalizing" splits in a few geographies. If this includes a cap, it could appear as if they've stemmed the tides on split erosion in the first few quarters of next year but should eventually converge towards market rates in back half. Sell side continues to expect a leveling out so any continuation of the trend should act as a catalysts
• housing market slowing considerably. If you talk to agents in California they're starting to see a slowdown in transaction volumes primarily led by rising interest rates and cyclical fears. Thus far Realogy has seen mid single digit housing price increases and positive volumes. When that turns it will be a problem as there will be fewer offsets for split and franchisee fee headwinds