Description

Realogy is a highly cash generative business trading at a very reasonable valuation. 

The stock has been hit recently on several concerns.  1) fear of rising rates 2) weakness at the high end of the market 3) management credibility.  I will address each one in this write up. 

Company description:

Realogy is a residential real estate franchising and brokerage firm.  RLGY has 13,600 offices with more than 257,000 sales associates operating under the brands of Century 21, Coldwell Banker, ERA, Sotheby’s International Realty, Better Homes and Gardens Real Estate, Citi Habitats, Corcoran, and Zip Realty.  RLGY also offers corporate relocation services, title insurance, and has a JV with PHH for mortgages. 

Quick history:

Realogy spun out of Cendant in mid-2006.  Soon after, the company was taken private by Apollo.  The deal closed mid-2007.  In hindsight, this proved to be a poor time to LBO a real estate firm.  The business declined substantially and RLGY’s unsecured bonds were left for dead.  At one point they traded to less than 10 cents on the dollar.  Shrewdly, Apollo was able to keep the company out of bankruptcy by buying up deeply discounted debt and injecting more than $1b in new money into the business.  This restructuring created a very large NOL.  Concurrently, management aggressively cut costs to remain solvent (and pay the ~$600mm in annual interest).  The number of employees was reduced by a third and over 350 brokerage offices were closed or consolidated.  In late 2012, RLGY went public and in 2013, APOL exited the position with two follow-on offerings.  The management team that presided over the turnaround is still in place today. 

Concern #1:  Fear of rising rates:

I think this risk is a bit misplaced as there are several offsetting factors. 

The most important driver of demand for housing is employment, not rates.  This metric is obviously quite healthy at present and the labor participation rate is finally starting to pick up.   Rates are probably only going to rise if the economy is doing well and unemployment rates are low. 

Credit availability is also tremendously important.  Banks got burned badly in the past crisis and have been slow to ease their lending standards.  However, there has been substantial progress on this front over the past couple years.  For one, housing policy has become increasingly accommodative (easing reps and warranties for lenders, lower FHA fees, etc.) which has helped the flow of housing credit.   While credit standards are still more stringent than normal, required FICO stores have gradually eased over the past several years.  This trend is showing no signs of abating. 

Regardless, a 200 bps rise in the long end of the curve wouldn’t change the dynamic that debt-service-to-income ratios are at historically high levels of affordability.  Meanwhile, national rent-to-median household income levels are well above normal levels.  Something has to give. 

Concern #2:  Weakness at high end of market

RLGY’s company-owned footprint is (deliberately) concentrated in higher priced residential real estate markets such as California, Florida, and New York.  Recent data (and scuttlebutt) has indicated that the high end housing market is softening.  There are several reasons for this.  The strong dollar is crimping foreign demand, the recent stock market swoons has increased buyer caution, and certain local geographies are becoming oversupplied (think NYC condos).  While it is likely that some markets will weaken, the magnitude of the impact on RLGY’s bottom line will be manageable.  Importantly, any weakening at company owned operations will be more than offset by the much larger opportunity for EBITDA growth in RLGY’s much larger franchise segment. 

Housing turnover (home sales / housing stock) is an important metric to measure where we are in the cycle.  Over the past 10, 15, and 20 years, housing turnover has averaged ~4.2% of the total stock.  2015 sales only represented 3.85% of the housing stock.  Any reversion to the mean on this metric would be particularly powerful for RLGY’s franchised operations where incremental revenue flows through at around 95% margins (as it is a royalty stream).  This is likely to occur for some of the aforementioned reasons (easing credit, accommodative policy, improving employment, etc.) as well as tremendous pent up demand in household formation. 

Concern #3:  Management credibility

Several analysts I’ve spoken with who have followed the name for a long time are frustrated with senior management (Richard Smith and Tony Hull).  I’ve repeatedly heard them described with words such as “arrogant”, “dismissive”, “flippant”, and even “untrustworthy”.  I’ve met them both on several occasions and don’t agree, but can see how they may come across that way.  Regardless, this isn’t a particularly difficult business to run from the C-suite, and I’m happy with their operating performance and capital allocation.  Therefore, while they may have rubbed some people the wrong way, it doesn’t really impact the fundamentals of the business. 

I’ve also heard gripes about their liberal use of non-GAAP accounting.  While I agree they’ve been aggressive with add backs and it is somewhat annoying, again, I’m not sure that it is particularly impactful on the intrinsic value calculation of any decent analyst.  Additionally, last quarter they introduced “operating EBITDA,” which is a much cleaner metric. 

Besides promotional accounting and questionable disposition, analysts have been particularly frustrated at management’s guidance regarding incremental margins which have come in well short of what Wall Street was originally spoon fed.  

In my view, this shortfall has primarily been driven by two legitimate explanations.  1) Heavy investments in technology, and 2) Declining contribution from the PHH mortgage JV.  I will address both.

Technology investments:  As the scale player in an otherwise fragmented industry, RLGY decided that it would be strategic to invest in superior technology capabilities (mobile apps, local websites, customized CRM platform, etc.) for its franchisees.  This makes a lot of sense because it increases the value proposition of the franchise offering (increased franchise sales, better franchise retention rates) and improves the productivity of the underlying brokers (leading to higher transaction volume).  In order to accelerate this initiative, in mid-2014 RLGY acquired ZipRealty, a fledgling discount brokerage trying to disintermediate (unsuccessfully) the traditional brokerage operation.  RLGY had no interest in the business, but Zip’s technology platform was robust.  Since the acquisition, RLGY has been spending heavily to adapt and optimize the Zip software to meet the needs of its franchisees.  The rollout is underway.  While it isn’t hard to argue that this technology investment could strengthen the moat (vs. competitors stuck in the stone age), it has burdened the income statement with investments that do not have an immediate and quantifiable near-term payback. 

Decreasing contribution from PHH JV:  RLGY’s mortgage JV has averaged $28mm of EBITDA since 2009 but has been very volatile due to the timing of refinance activity driven by the path of changes in mortgage rates.  The refinance boom of 2012 pulled forward a tremendous amount of demand and resulted in an impossible comparison.  The JV contributed $62mm of EBITDA in 2012 vs. $16mm today.  That decline has obscured the incremental margins of NRT, the company owned franchise segment. 

Additional concern:  Risk of disintermediation:

I view this issue as another misperception that has hurt RLGY’s multiple.  I have spoken to a number of people on this name who have expressed concern that the business could face disintermediation.  So far, the numbers do not support this fear.  From 2001 to 2015, the percentage of houses sold using an agent rose from 79% to 89%.  In the meantime, there have been a number of attempts to introduce cut-rate online brokers.  All have failed to catch on.  So despite the “internet,” for-sale-by-owner has actually declined significantly.  Some people have brought up online portals like Zillow and Realtor.com as risks.  But their entire business model (selling ad space to realtors) only further entrenches the current system. 

Manageable leverage:

Management has now deleveraged and refinanced its entire crisis era capital structure.  Net debt/EBITDA has declined from 12.3x in 2011 to 3.9x today.  Over the same time period, interest coverage has increased from .9x to 4.8x (based on ’16E).  Covenants are minimal.   For this reason, management recently announced they would begin buying back stock. 

Valuation:

I project that RLGY will earn ~$2 of fully taxed earnings in calendar 2016.  The company has $95mm of intangible amortization, which on a fully taxed basis adds another ~$.40/shr.  So ~$2.40 of fully taxed owners’ earnings.  The company will not pay cash taxes for the next three years due to the aforementioned NOLs.  I value the tax benefit at a NPV of ~$3/share.  At today’s price minus $3/share, you are creating the business for ~$29.50/~2.40 = a touch over 12x owners’ earnings.  This seems far too cheap for a business of this quality that I would argue is below mid-cycle. 

Looking at it another way, I have them generating ~40% of the current market cap in FCF over the next 3 years (at which point they will be a full cash tax payer). 

My FMV is based on a DCF and results in a target price of ~$50/shr. 

Conclusion:

The opportunity to buy a Warren Buffett quality business (Berkshire owns one of the largest competitors) for a well below market multiple doesn’t come around that often.  The stock is the cheapest it has been since it went public in 2012.  The balance sheet is finally in order which frees up RLGY to pursue tuck-in acquisitions within its company owned footprint (these deals are highly accretive as RLGY is an advantaged acquirer with tremendous synergies).  Management expects to do $75-100mm of deals this year.  Management is battle tested and well incentivized to continue producing robust earnings and cash flow.  In fact, both the CEO and CFO recently reached into their pockets and acquired stock at these levels on the open market.  The company is investing in the long run and should benefit from a healthy macro tailwind as the housing market continues to recover. 

Catalyst

Robust cash flow