Description

Idea:

Realogy (“RLGY”) is a high quality business with substantial exposure to a U.S. residential real estate recovery. While we expect an eventual recovery in existing home sales to more normalized levels, even absent a substantial uptick in housing, RLGY seems likely to be able to grow revenues at ~5% for many years to come. RLGY also benefits from a substantial NOL (11% of market cap), rapidly falling interest expense (both from de-leveraging and re-financing expensive crisis-era debt) and minimal capex needs due to franchisor model, which should result in FCF of ~$4 by 2018. Once leverage has fallen from 4.4x today to 3x targeted level, management has committed to return capital to shareholders.

Business Description:

RLGY is a collection of four real estate related businesses in the U.S. These consist of the following:

1.       RFG: Largest franchisor of residential real estate brokerages in the world. Capital light, toll bridge operator, that collects a royalty on any brokerage transaction. EBITDA margins of ~65% (58% of EBITDA)

·         Key brands are Century 21, Coldwell Banker, Better Homes & Garden, ERA, Sotheby’s International

·         Economic model: Existing Home Sales x Home Price x Broker Fee x RLGY Royalty %

·         Average franchise tenure is 20 years (vs 11 year industry ave)

·         Franchisee retention rate is 98%

·         No franchise accounts for >1% of revenues

2.       NRT: Owns and operates the largest U.S. residential real estate brokerage. Positioned in larger MSA’s with ave sale price 2x the national ave (25% of EBITDA)

·         #1 or #2 in most markets operating with a concentration in NY (24%), CA (28%), FL (10%)

·         Economic model: similar to RFG except instead of merely skimming a franchisee fee, RLGY takes the full revenue and associated cost associated with the brokerage

3.       Cartus: Outsourced provider of relocation services (12% of EBITDA)

4.       TRG: Commercial underwriter of title insurance policies (5% of EBITDA)

Cartus and TRG are decent businesses that make sense to keep together with the core real-estate entities as a result of natural cross-selling opportunities.

Variant Perception:

·         Housing recovery: We believe a housing recovery is eventually inevitable. Existing home sales peaked in 2005 at 7.076 million, troughed in 2008 at 4.124 million, and have been making their way through a grinding recovery, with 2015 sales likely to end up at ~5.3M upon final tally. We believe there have been two factors that have depressed existing home sales following the 2008-09 crash: 1) household formation fell off a cliff: people moved back in with their parents and stayed at home longer, 2) home ownership rates fell from a high of 69% in 2006 to a low of 63.4% in Q2 2015. We believe both of these factors are now moving in the opposite direction. Household formation has recently picked up and the home ownership rate has recently risen, after being at a level not seen since the 1960s. One analytical note - rather than look at the absolute numbers, we look at existing home sales as a % of existing households.  From this, we believe existing home sales could grow 5%+ annually over the next couple years. We also think home prices in the U.S. continue to be affordable, but only underwrite CPI +1% growth (current run-rate is +4.7%). This volume and price outlook give us ~8% revenue growth over 2015-2017.   

·         Margin improvement: If a housing recovery materializes, we believe RGLY’s margins are likely to continue to rise from 14.1% in 2015E to 16.2% by 2018E. Consensus calls for margins to expand by <50bps, and several analysts point out that the best margins RLGY ever achieved were in 2006 (16.3%) on record volumes and home price appreciation. We would highlight that RLGY was a former Apollo LBO, and during the downturn the mgt took out $557M in costs during the downturn (headcount reduction, consolidating offices from 1.1K to 700), shifting marketing spend from print to digital and exiting unprofitable lines). Based on our conversations with mgt and our work on the fixed/variable cost structure, we think margins should nicely rise if volumes and price improve. 

·         Levered equity stub: RLGY IPO’d at the end of 2012 with 6x leverage, which has subsequently been reduced to 4.0x. Despite that, the stock is now less than where it closed on its first day of trading. Going forward, even if a housing recovery does not materialize, we think value continues to accrete to the equity holders as debt continues to be paid down, and mgt has consistently promised return of capital once leverage has reached 3x (we think we will be there by the end of 2016). RLGY also has a $2B NOL which will shield it from being a cash tax payer for several more years and thus enhance the equity accretion.

·         Just too cheap: The bulk of RLGY’s business is a franchise royalty stream which has minimal capital requirements and very high ROIC. Similar businesses (hotel franchises and restaurant franchises) often trade at 12-14x EBITDA. RLGY trades at 9x 2015E EBITDA and 8.2x 2016E EBITDA, and 12.2x unlevered 2015E FCF (fully-taxed). We think we could see a significant multiple re-rating in the years to come.

Price Target:

·         We think RLGY can do $4 in FCF in 2018. Applying a 16x FCF multiple yields a $64 stock, plus we are likely to see ~$8 of dividends during that time vs today’s price of $33, which would be over a double. 

·         Even in the event that housing continues to be weak, we are buying a wonderful business at 12x fully-taxed ‘15E FCF and will continue to benefit from rapid deleveraging from FCF conversion

Another Consideration re Attractiveness of the Space and Rationality of Competition:

For what it’s worth, we would also note RLGY’s next largest competitor is Berkshire Hathaway Home Services, and Buffett continues to devote significant capital to buying additional brokerages.

Catalyst

• Recovery in existing home sales and home prices
• Ongoing deleveraging and eventual return of capital