- A highly recurring revenue stream with low renewal risk should allow Brookfield Real Estate Services ("BRS") to continue to grow its annuity-like cash flow.
- The fully covered cash dividend was recently increased, and now yields 8.5%.
- BRS stable shareholder structure includes Brookfield Asset Management ("BAM"), owning a 26% stake.
- Shares have 30 to 40% upside based on a discounted cash flow ("DCF") analysis, and limited downside based on the business model and psychological factors of a nearly double-digit dividend yield.
Investors looking to hide out from continued equity market volatility may want to consider little known, Brookfield Real Estate Services [(OTCPK:BREUF)(BRE.TO)] ("BRS"). Not only is BRS undervalued at its current $130 million valuation, but it maintains a defensible moat in the Canadian real estate services sector, and provides investors reliable, consistent and growing cash flow.
Today, BRS represents a compelling asymmetric risk/reward investment, not for huge capital appreciation opportunity (although I do think the company is undervalued), but because the company throws off cash flow that has annuity-like characteristics making BRS a fairly low risk investment opportunity.
BRS is engaged in the Canadian real estate sector. The company is capital light and "generates cash flow from franchise royalties and service fees derived from a national network of real estate brokers and agents in Canada operating under the Royal LePage, Via Capitale Real Estate Network and Johnston & Daniel brand names."
BRS is a subsidiary of Brookfield Asset Management (BAM) ("BAM") who owns a 26% interest in BRS and acts as the external manager for BRS in connection with a Master Services Agreement ("MSA"). Therefore, BAM receives (1) advisory fees; (2) dividends; and (3) its commensurate share of BRS's market value. While BAM does receive an advisory fee ($6.8 million in 2012 and 2011) which reduces the cash flow available to the equity, BAM's interests are aligned with shareholders given its 26% stake in the business.
The advisory fee is determined in accordance with the MSA, and is calculated as 30% of net royalty fees earned from the Via Capitale franchise agreements and 20% of the balance of royalties less administration and interest costs for the Royal LePage franchise agreements. 
I should note that concerns exist relative to the earnings quality of BAM given the complex holding company structure under which it operates. This could be one reason why this particular opportunity exists given BAM's significant influence over BRS. The opportunity likely also exists because the Canadian real estate market is generally believed to be overvalued (but shouldn't affect BRS as much as investors think for reasons discussed below) and that BRS is too small at its $130 million market cap for big players to allocate capital.
That said, the Brookfield entities have shown a propensity to alleviate discounts in its underlying businesses, including buying out the public float of its subsidiaries. One recent example I highlighted included Brookfield Property Partners' (BPY) offer to acquire the shares of Brookfield Office Properties (BPO) it didn't already own. Because BRS trades at a wide discount to my estimate of value, I suspect management may be assessing ways to unlock the inherent value of BRS similar to the BPO deal.
Speaking of unlocking value, BRS management just raised the monthly distribution from $0.092 cents ($1.10 annualized) to $0.10 cents ($1.20 annualized), equating to an 8.5% dividend yield which is well covered by the cash flow generated by the business. That substantial dividend yield, in my opinion, limits the downside risk in these shares as lower prices would push this safe dividend's yield up to double digits.
BRS derives its revenue from fixed and variable franchise fees it assesses to the network of realtors that use BRS's brands and lead generation services to sell residential and commercial real estate.
As of September 30, BRS claimed ~15,500 real estate professionals under its umbrella of brands and 24% market share in the Canadian residential resale market.
Because of the recurring and fixed nature of BRS's revenue model, revenue growth can be achieved by (1) increasing monthly fees and (2) adding paying realtors to the BRS network, organically or through acquisition of franchise agreements. Management raised the monthly dues by 2% beginning in January 2014. In addition, management added roughly 2.5% to its realtor count since the end of 2012. Both of these levers should have an accretive effect to both top line revenue and cash flow growth.
As a potential investment, what I like about the revenue stream is that it is highly predictable given most of the franchise agreements have 10 commitment durations, much longer than the 5-year industry standard. Nearly 75% of the revenue base is fixed and recurring in nature, with the remaining based on transactional volume. Therefore, even a black swan event in the Canadian real estate market would not affect most of BRS's revenue stream given the high proportion of fixed monthly dues and long dated franchise agreements.
Here is the franchise renewal timeline as reported in the latest quarterly filing:
I understand BRS has historically benefited from 99% renewal rates on its franchise agreements, measured by number of realtors. Therefore, I think the renewal risk here is minimal.
In terms of modeling, this is a straight forward business to assess from a discounted cash flow ("DCF") approach given the visibility of its annuity-like income stream. Because the lion's share of the revenue stream is fixed based on monthly fees assessed to BRS agents, I am estimating top line revenue and cash flow growth at 1% a year in perpetuity as BRS is able to pass through slightly higher franchise dues to its agents and grows the number of realtors using its services. There is a certain element of variability related to transaction volume, but I am choosing to hold that factor constant for sake of simplicity and the fact it makes up a minority of BRS's value proposition. I used a 12% discount rate to value the equity.
Using these assumptions, my model indicates $235 million in business value. After backing out debt of $52 million, the equity is worth about $180 million, or about 35% higher than the market is pricing the equity today. At a $235 million estimate of enterprise value, the business is priced at about 9x my estimate of 2014 operating cash flow. In my view, a private business owner would be willing to pay a 9x multiple of operating cash flow for control of this business and its highly visible, annuity-like income stream.
Add in the fact that BRS is encumbered by $32 million of fairly high (5.8%) interest debt (matures in February 2015) in the current lending environment, and a small catalyst is on deck either through retiring or refinancing that debt at lower rates which would release even more equity value. The remaining debt balance is made up of a $20 million credit facility at a floating rate, prime plus 1.5%.
Finally, to provide a gut check on the valuation, the $235 million enterprise valuation falls generally in line with historical prices. However, I think the business (equity) is more valuable today than it was previously on account of the recent 2% increase in the monthly dues, the higher number of realtors under the BRS umbrella and as evidenced by the increased monthly dividend distribution.
There is continued news out of the financial press that the Canada real estate market is overvalued. Most recently, TD Ameritrade and the International Monetary Fund released a report indicating the Canadian residential real estate market to be 10% overvalued. However, the risk here isn't that the real estate is overvalued, rather that there is another credit crunch that dries up the real estate sales funnel. In fact, I would suggest that volatile residential real estate prices could increase the velocity of sales, thereby increasing the transactional volume. In the event of a credit crunch, BRS has stability in its revenue stream from its fixed monthly franchise fees.
The key to BRS, however, is that it doesn't have exposure to real estate, in terms of owning the asset class, per se. Rather than owning real estate, it simply collects monthly dues and a "toll" on the transaction volume from its agents. BRS CEO Phil Soper discussed the current environment in the latest MD&A:
We saw the housing market emerge from a 12-month correction in the third quarter of 2013, the ﬁrst period of solid expansion for both house prices and sales volumes since the Ministry of Finance instituted new mortgage rules in July 2012. In the previous four quarters, there was a marked decline in the number of homes trading hands, which kept house prices relatively ﬂat in most markets. That trend was reversed in Q3 as homebuyers returned to the market in large numbers, pushing values northward.
Put differently, the BRS business model won't collapse if the Canadian real estate market experiences a decline in prices. BRS earns a 1% fee on the transactional volume of its agents, so the velocity of transactions does have an impact on BRS. But because nearly 75% of BRS's revenue stream is fixed, however, I think it is pretty well insulated from a dislocation in the Canadian real estate market.
Given BRS operates real estate brands with a long history including Royal LePage, Via Capitale and Johnston & Daniel, I think the risk of permanent loss of investment capital at the current valuation is unlikely. The business model is strong, and should weather any temporary disruption in the industry while continuing to pay shareholders a solid dividend along the way.
The "alpha" in these shares comes from the risk side of the equation, specifically from the highly visible and recurring revenue stream from its long dated franchise agreements and high renewal rates with its realtors. Downside should be limited due to the high dividend yield and stable cash flows underlying this capital light business. If this safe dividend approaches a 10% yield, I suspect there would be some buying interest in these shares.
Investors should note that these shares are much more liquid on the Toronto Stock Exchange. From a currency risk perspective, investors have pretty clear visibility into the dividend stream so currency risk can be hedged away if the price is right.
Relative to my ~35% estimate of upside in these shares (not including the monthly dividend stream), I think investors are taking below average risks here (about 10 to 15% to the downside) for a solid return profile. A 1 to 3 risk/reward ratio for a high-quality business is a good bet, in my opinion.
 2012 Annual Report, pg. 24