Royal LePage Franchise Services is a market leader with huge margins, plenty of opportunity for growth, a 10% yield that is more than covered by cash flow generation and a franchise-based business model with recurring revenue and virtually no capex. This opportunity exists due to the recent tax legislation which has brought down the price of virtually all Canadian Income Trusts due to the uncertainty surrounding their tax-favored status which may be taken away in 2011. I believe this is an attractive opportunity even if the proposed changes take place and the company can not remain an Income Trust. 

 

Royal LePage is the largest provider of real estate services in Canada.  The Income Trust holds the rights to the franchise agreements with the company’s residential real estate brokerage franchises, which operate under the Royal LePage and Johnston & Daniel brands.  This network accounts for roughly 12% of the realtors in Canada and 20% of the country’s transactional volume.  Royal LePage has been around since 1913 and has a strong brand name in Canada.  In 1987 Brascan (now Brookfield Asset Management) bought 54% of the company, which was eventually privatized as a wholly owned subsidiary of Brascan in 1999.  In 2003 the Fund was publicly listed as an Income Trust with Brookfield retaining a 25% stake, and Brookfield continues to manage the fund through its residential real estate services division.  The fund units recently fell from over $14 to the current price of $11.50 which I believe offers an attractive opportunity for the following reasons:

 

Royal LePage has a market cap of $115 mm and EV of $172 mm (all numbers are in Canadian dollars).  The fund paid out $10.9 mm in cash distributions in 2005 and is on pace to pay out $11.5 mm in 2006, representing a 10% distribution yield.  Even better is the fact that the company generates significantly more cash than it distributes – for example, over the last 12 months the company has paid out $11.3 mm but has actually generated over $19 mm of cash.  $3.8 mm of the $19 got distributed to Brookfield, although their shares are subordinated until August 2008 and they do not get paid their dividend until after the public shareholders do.  The rest of the cash is held to reserve against future market volatility and to make accretive acquisitions. 

 

Also worth noting is that the $19 mm is actually a bit low due to the way the company accounted for its management fee, which was increased by $1.9 mm in Q1 2006 due to the fund’s previous accounting method.  Essentially part of the management fee that was earned in previous quarters was withheld until the company did something with that portion of the cash that came in, which they held until it was used in Q1 to make acquisitions.  Going forward the entire management fee will be paid out on a “when earned” basis.  So the actual cash generated should have been over $20 mm for the last 12 months, representing over 17% of the current market cap and almost 12% of EV.  Even assuming a haircut for the future tax changes (20% has been suggested in previous write-ups and seems fair, if not overly conservative) this is a cheap price for a company with a strong business model, good growth prospects, and quality management. 

 

Royal LePage’s franchise model results in strong cash flow generation and large returns on capital.  The fund is paid royalties by its network of over 12,000 realtors.  A large portion of these royalties are fixed, typically $100/month for each realtor.  The company is also paid variable royalties, which are typically 1% of its agents’ gross income but can be as high as 5% in higher-end markets such as Toronto.  The franchise contracts the company enters into are for 10 to 20 years.  The company enjoys huge EBITDA margins of around 80% and has virtually zero capex.  The company also benefits from its size – Royal LePage’s realtors’ average 64% more sales/year than the average Canadian realtor, in large part because of the company’s strong brand name, scalable advertising, and services such as the company’s website.  The company also leverages its size and experience by training agents to help them with marketing, business planning, employee retention, recruiting, etc.      

 

As the market leader in a fragmented industry, Royal LePage has plenty of room to grow beyond its 20% market share.  With its excess cash flow it plans on purchasing independent local real estate companies that are accretive to its existing platform.  In 2004 it acquired 39 franchises with 558 agents and in 2005 it acquired 21 franchises with 346 agents.  In both years the company has grown more via organic expansion than through purchases but acquisitions remain a key part of the future growth strategy.

 

HomeServices of America, a Berkshire Hathaway company with the #2 market share in real estate brokerage in the U.S., has pursued a similar strategy recently, gobbling up independent firms that have strong local presences in the U.S.  Just this year it bought a firm in Atlanta with 1200 realtors and one in Cincinnati with 700 realtors, and has made 20 such acquisitions since 1998.  Buffett has spoken enthusiastically about this business:      

 

“MidAmerican also owns a significant non-utility business, Home Services of America, the second largest real estate broker in the country. Unlike our utility operations, this business is highly cyclical, but nevertheless one we view enthusiastically… Home Services is almost certain to grow substantially in the next decade as we continue to acquire leading localized operations.” (2003 Annual letter)

 

This appears to be an industry that is ripe for consolidation and in the Canadian market Royal LePage has the best position to take advantage of that trend. 

 

For a small Canadian Income Trust this company has an unusually strong management team.  I view the presence of Brookfield as a significant positive due to their experience, resources, and investment acumen.  Brookfield’s COO, Georg Myhal, is the Chairman of Royal LePage’s board.  Most of the fund’s management team has been involved with the company since the mid-1990’s.  The fact that Brookfield’s cash distribution is subordinated to public shareholders through August 2008 gives me faith that they believe in the future of the business and the stability of its cash flows. 

 

While this business has a significant degree of cyclicality it is almost certain to grow over the long term.  Another Buffett quote about HomeServices:

 

“…MidAmerican owns the second largest real estate brokerage firm in the U.S. And it’s a gem… Currently, the white-hot market in residential real estate of recent years is cooling down, and that should lead to additional acquisition possibilities for us. Both we and Ron Peltier, the company’s CEO, expect HomeServices to be far larger a decade from now.” (2005 annual letter)

 

Because of its market leading position and strong cash flow Royal LePage will be in a similar position if the Canadian market takes a turn for the worse.  The fact that its average agent has 64% more sales volume in a year versus the average Canadian realtor is also an important factor – it is the small, independent firms that will struggle the most in tough times and may become attractive acquisition candidates for the fund. 

 

Royal LePage’s fixed fee structure also helps to smooth its revenue base.  While the company’s variable fees are dependant on the overall real estate market, its fixed fee base is quite stable.  While the overall market has done well the past few years it remains quite seasonal and by looking at the quarterly numbers you can see that the fixed fee base is not affected by moves in either direction for the overall market:

 

	2003	2004				2005				2006
	Q4	Q1	Q2	Q3	Q4	Q1	Q2	Q3	Q4	Q1	Q2	Q3
Royal LePage Revenue
Fixed Fee ($ 000's)	2,465	2,522	2,718	2,691	2,718	2,945	2,999	3,127	3,261	3,380	3,453	3,485
Variable Fee	1,169	1,179	2,008	2,041	1,149	1,335	2,231	2,444	1,327	1,610	2,498	2,377
Premium Fee	930	541	932	1,489	1,009	576	1,103	1,497	1,065	688	1,125	1,685
Other	638	613	739	731	660	740	805	869	872	814	856	923
Total Revenue	5,202	4,855	6,397	6,952	5,536	5,596	7,138	7,937	6,525	6,492	7,932	8,470
Total Canadian Market
Transaction $ volume (mm)	20,209	23,698	33,187	25,873	21,335	24,814	37,809	32,190	25,601	30,585	42,607	33,200

 

While a macro view on Canadian real estate is not central to this thesis, the market does not appear to be as overheated as in the U.S.  Residential real estate has grown at about 10% compounded since 1980, and recent year over year increases in average selling prices have been in the 7%-13% range.  The market has had two significant downturns, in 1990 and 1995, but both took less than 24 months to get back to pre-downturn levels.  At any rate the long-term future of this business should not be greatly affected by short-term moves in the overall market, although there could definitely be some volatility. 

 

CEO Phil Soper recently stated that it is too early to tell what the impact of the legislation will be on Royal LePage.  Even if the company can not remain an income trust I believe it is cheap today.  While some income trusts will struggle to find ways to use their cash if they have to switch to a normal corporate structure, Royal LePage has plenty of opportunities to deploy cash via accretive acquisitions and a smart management team with aligned interests that will recognize the best use of capital.  The company also has $127 mm of intangible assets available for amortization (current rate is around $14 mm/year).      

 

There is likely a secular trend driving down the fees that realtors charge - 20 years from now it is almost certain that they will be paid a lower % commission due to the internet, increased transparency, competition, etc.  This risk is mitigated by the fact that there will also be many more transactions taking place at higher prices in 20 years.  At any rate the deterioration of commissions will be a slow process that should not have a significant effect on Royal LePage’s continued ability to grow and generate cash.       

 

-Investors discover a quality business with strong cash flow generation at a bargain price

-Income Trust turmoil dies down

-Continued 10%/year cash flow distribution