Realogy: Little Upside For Investors

Summary

• Realogy is struggling to deal with competition from new brokerages.
• Direct home buying startups are threatening to disrupt the traditional independent agent model.
• The company's debt load could become an issue if its business deteriorates further.

Realogy Holdings (RLGY) is a dominant player in the real estate brokerage business with almost 200 thousand in independent sales agents in the United States, along with over 100 thousand agents internationally.

Its Coldwell Banker franchise is the dominant brokerage in the US. Despite this, the stock has been in a major slump for years. The stock price traded over $50 per share in 2013 and is now below $20 a share.

Brokerages make money by taking a percentage of each real estate transaction. As new competitors have emerged, that percentage has come under incredible pressure. Startup brokerages like Compass and eXp Realty (EXPI) are putting incredible pressure on traditional brokerages.

Compass, in particular, has been aggressively poaching agents with attractive offers Realogy can't profitably match. It's hard to compete with a startup funded by SoftBank (OTCPK:SFTBY). This has led to consolidation in the industry as smaller brokerages struggle to stay competitive.

Realogy hasn't been able to benefit from this consolidation, as new startups have emerged, threatening to disrupt the real estate industry. The company is in a desperate race to retain its industry position, as explained in its conference call:

Second, in our own brokerage business, we continue to move quickly on new commission pricing designed to attract faster growing and higher-producing agents... This initiative is all about growth. We are leveraging these new plans to attract more agents quickly, while allowing our existing agents to continue on their existing plans or explore the new plans where appropriate.

Translation, the company will be pocketing a lower percentage of real estate commissions so Realogy can retain agents. New competitor eXp Realty offers a cloud-based brokerage and takes a very low cut.

eXp can do this because it doesn't have expensive office leases and on location staff. Agent growth is exponential currently at eXp, and Realogy can't match its cost structure.

Redfin (RDFN) is further putting pressure on agents' commissions with the discounted commissions offered by its own employees. Lower commissions mean pressure on revenue growth.

If this wasn't bad enough, direct home buying startups like Opendoor are trying to make traditional real estate agents' role in a transaction obsolete. These startups offer convenience and security that Realogy can't match.

Zillow (Z) and Redfin have also got into the direct purchasing business. While Realogy has a partnership with a company to do direct home buying, it's way behind competitors like Opendoor, Zillow, and Redfin, and doesn't have the visitors that Zillow and Redfin attract to its website and app.

What Realogy has going for it is its established market position. The company should be more resilient than the smaller brokerages, and should be able to steal market share from them at least temporarily.

The question is how popular will direct home buying get. There has been tremendous interest already, as Opendoor is planning on buying billions of real estate in 2019. There is also a lot of room for improvement as new technologies like AI alter industries.

The transition won't happen overnight, and buyers and sellers often have strong relationships with their preferred agent, but I believe the time has come for the real estate industry to finally be disrupted by technology.

While the stock price is trading at extremely depressed levels, the business has deteriorated as well, making Realogy only reasonably priced, in my view. Leverage is also a concern, so I can't justify investing in the company.

Moderate Valuation

Long-term debt has been coming down, but it's still elevated, making Realogy vulnerable if its results keep deteriorating.

RLGY Total Long Term Debt (Quarterly) data by YCharts

The company has used earnings to buy back stock over the years.

Since the share repurchase program's inception in February 2016, the Company has repurchased approximately 29 million shares through September 30, 2018 at an average price of $26.74 for $776 million. As a result, Realogy had approximately 120 million shares of common stock outstanding as of September 30, 2018.

In hindsight, this money would have been better used to pay off debt. Realogy is going to have to be aggressive to compete, and the company's high leverage decreases its ability to significantly fight back.

Net income has declined slightly in the first nine months of 2018. While margins have held up, they were never really high to begin with.

RLGY Gross Profit Margin (TTM) data by YCharts

The strong economy has been helping results, but with housing price appreciation and sales slowing, financial results will be under pressure.

While it's trading at a record low EV-to-Revenues ratio, margins should be razor-thin in the future, and I believe the stock will trade well below a 1 EV-to-Revenues ratio going forward.

RLGY EV to Revenues (TTM) data by YCharts

There's just too much competition, not to mention its increasingly obsolete business, for me to feel confident investing in the company. Even if Realogy can retain market share, it will likely have to decimate margins to do so. Brokerages have little leverage over their own agents, as agents are the ones who work with buyers and sellers directly.

Revenue growth is looking increasingly unlikely as commission rates for agents come under pressure from Redfin, so there is little upside for investors. There are better value stocks on sale. While a short-term bounce back looks likely, Realogy's long-term prospects are bleak.

Analyst’s Disclosure: I am/we are long EXPI, RDFN. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

I'm an independent sales agent in California with Compass.

Comments

[MoS35]

Absolutely, who wouldn't? The problem with determining what will happen in the short-term is that everything is more random or has a higher variance in the short-term. Flip a coin 10 times versus 100 times and see which is closer to a 50/50 split. After the fact, if one has the means and the business has not fundamentally changed, the correct thing to do is take advantage of the discount. The move had more to do with where we are in the business cycle and RLGY's debt load than the earnings miss. The earnings miss is trivial (~$9mm), but the debt load at a 4.6x multiple and likely going up above 5x next quarter, is clearly the market's concern. I was pleased to hear that they will be focusing on buying back debt over the next two quarters.

[MoS35]

@Dinesh Sarda , in the short-term anything can happen. If you listen to the call you'll see the stock is reacting to the housing market and its near-term outlook. Let's revisit in a few years. Have a look at the company's fcf generation and then you tell me whether or not the equity is cheap.

[Dinesh S]

I agree short term move is not everything..But if you can buy same share by waiting to go long at 30% less price , i will prefer that

[MoS35]

@Scott Perry , You might be thinking this a little too hard. Home sales across the US are down ~ 20% since the end of last year. Realogy's sales are up about a little over 1% over the same time period. To me, that sounds like they are gaining market share. Secondly, since 2013, the company has purchased about 15% of its shares outstanding and has reduced long-term debt by ~ 50%. Thirdly, historically, EV/EBIT ratios for this sector have averaged north of ~15x, as has the market's (Note: at 15x EV/EBIT, RLGY's equity valuation would be ~ $44/sh). Private equity has been paying ~11x EV/EBITDA for all companies this year, which is rich, but it's a data point. As this type of company has small capex relative to other companies, EV/EBITDA might be the easiest way to get a valuation. At 9x EV/EBITDA, which is Private Equity's long-term average for buying companies (especially for an established, brand name, money-making brokerage like Realogy), you get an equity valuation of ~31.50 assuming no growth. What would you pay for growth ~ 1x? At 10x, you get an equity valuation of ~ $38/sh. I'm not a genius, but a double from current share price is a fairly large margin of safety. And ~10x, IMO, for a brand-name, money making company with a long history of cash flow generation is cheap.
Anecdotally, I don't know your history in the sector or how many houses you've bought and sold, but unfortunately it's very difficult to get around real estate brokers as they do add a lot of value to the process. Another anecdotal observation is Berkshire's foray into the sector. Why would he do that if RLGY's part of the sector is dying?
Btw, RLGY's operating margins have been extraordinarily stable and have improved over the last year.

[stockreader2014]

total agree with your comment. RLGY is way undervalued. When it comes to Value this author dont know what he is talking about. Wouldn't be surprised if private equity came in offer $35 a share

[Dinesh S]

@Scott Perry

Great call from Author.