Value Investors Club / Brookfield Real Estate Service (BRE.UN)

Description

Brookfield Real Estate Services Fund (BRE.UN on the Toronto Stock Exchange) was written up on VIC two years ago by trev62 under the company’s prior name, Royal LePage Franchise Services Fund. The new name was effective October 31, 2007. I encourage you to read that write-up, as it provides excellent background on the company and the industry. Rather than repeat all this background information, my report will focus on updating developments at the company over the last two years, and will attempt to analyze the potential impact of the current deteriorating economic environment on the prospects of the company.

First, a key impetus for posting this idea at this time is the current stock price. When trev62 posted the idea on 11/29/06, the stock was at $11.50, and the cash distribution rate was $1.15 annually, for a yield of 10%. (All currency numbers in this report are in Canadian dollars.) The stock price is now $7.60, and the annual distribution rate is $1.40, for a yield of over 18%. (As is typical with these Canadian income trusts, distributions are made monthly to investors.) There is a reasonable likelihood that this dividend will be cut in the next year or two, though I believe that it is also possible that management is able to maintain the current dividend through the rough times ahead. I will discuss this later in the report, along with my “worst-case” scenario analysis of earnings as the Canadian economy and real estate markets weaken. My conclusion is that in my “worst-case” scenario, a dividend cut will still result in a 10% to 12% yield on the current stock price, providing a big margin of safety to an investor at today’s price.

The bottom-line for me is:

(1) We are paying an incredibly low price,

(2) For the market leader in a cyclical industry,

(3) For a company with excellent economics and a strong balance sheet,

(4) And receiving a very handsome cash dividend (18% yield currently),

(5) While we wait for the industry to hit bottom and the stock price to bounce, or the company to be acquired at a good price.

Business Overview & Developments Since 2006

Brookfield Real Estate Services Fund (BRE) provides services to residential real estate brokers in Canada. The company franchises the rights to the three real estate brokerage brands in controls, and receives franchise fees from the brokers who use its networks. Prior to 2008, the company owned two brands: the Royal LePage brand, a national broker; and the Johnston & Daniel brand, which is a high-end real estate boutique serving Toronto and surrounding areas. (Johnston & Daniel is considered to be a sub-brand of the Royal LePage brand.) Effective January 1, 2008, BRE acquired a third real estate brokerage brand. The recent acquisition is La Capitale Real Estate Network, which was founded in 1991 and is focused on Quebec real estate. La Capitale added 1,060 realtors in 44 locations to BRE’s network.

	6/30/08	2007	2006	2005	2004	2003
BRE Number of Realtors (end of period)	14,771	13,172	12,149	11,542	10,145	9,454
Total Realtors in Canada	98,072	94,506	88,906	82,852	76,752	71,267
BRE share of Realtors	15.1%	13.9%	13.7%	13.9%	13.2%	13.3%

The table above shows the growth in BRE’s network of realtors since 2003, and its market share of the number of realtors in Canada. As of 9/30/08, Brookfield had 14,766 realtors in its network. This represents just over 15% of the overall number of realtors in Canada, up from 13.7% at the end of 2006 and 13.2% at the end of 2004. Importantly, Brookfield’s agents are far more productive than the average realtor in Canada, outselling the rest of the industry by an average of 70% in 2007, based on transactional dollar volume. At the end of 2007 (prior to the La Capitale acquisition), BRE’s network had 13.9% of the overall realtors in Canada, but for the year it had a 21% share of the Canadian residential resale real estate market, based on transactional dollar volume.

According to management, in 2007, 67% of BRE’s revenues came from what it considers “fixed” fees, directly tied to the number of realtors in its network, with the remaining 33% coming from “variable” fees, linked to transactional volume. (The way management calculates this 67% is not as straightforward as one would expect, and I will address this in my sensitivity analysis for a “worst-case” scenario later.)

Because of the franchising nature of the business, BRE has a wonderful business model, with a very large component of its revenues coming from fixed fees, and very low fixed costs. Looking at the table below, on the revenue side BRE receives a fixed fee of $100 per month per agent for all of the Royal LePage and Johnston & Daniel agents, and $170/month/agent for the La Capitale agents. These fixed fees are reflected in the “Fixed Franchise Fees” line. Additionally, for the RLP and J&D agents, BRE is paid 1% of the gross commissions received by each agent, subject to a maximum of $1,300 per year per agent. These revenues make up the “Variable Franchise Fees” line in the income statement. 22% of the RLP and J&D agents exceed the $1,300 per year cap (i.e. they earn gross commissions of at least $130,000 per year). The “Premium Franchise Fees” are higher commission-based fees, typically 4%-5%, charged to a limited number of agents (about 1,000 agents) in the Greater Toronto Area, for the privilege of using the RLP name in the most coveted market in the country. Finally, “Other Fee Revenues and Services” is primarily revenue from a $20/agent/month fee paid by most RLP offices for other services provided, such as technology services to agents.

On the expense side, the current overhead expenses (classified as “Administration Expenses”) are $800K per year. Interest expense currently runs at $3.2 million annually. The “Management Fee” is a variable fee, paid to parent Brookfield Asset Management for the services it provides, and is 20% of revenues less administration expenses and interest expense (30% for the recent La Capitale acquisition, which represents about 7% of revenues currently).

	TTM
	9/30/08	2007	2006	2005	2004

Revenue:
Fixed Franchise Fees	16,995	14,872	13,827	12,332	10,649
Variable Franchise Fees	8,363	8,566	7,832	7,337	6,377
Premium Franchise Fees	4,861	5,290	4,488	4,241	3,971
Other Fee Revenue and Services	4,372	3,763	3,512	3,286	2,743
Total Revenue	34,591	32,491	29,659	27,196	23,740

Expenses:
Administration Expenses	(785)	(725)	(645)	(595)	(513)
Management Fee	(6,373)	(5,869)	(5,323)	(3,660)	(3,660)
Interest Expense	(2,986)	(2,419)	(2,401)	(2,289)	(1,327)
Amortization of Intangible Assets	(15,974)	(14,804)	(14,559)	(14,150)	(13,677)
Total Expenses	(26,118)	(23,817)	(22,928)	(20,694)	(19,177)

Earnings before taxes	8,473	8,674	6,731	6,502	4,563

"Distributable Cash"--excludes amortization	24,447	23,478	21,290	20,652	18,240

Total shares outstanding	13,310	13,310	13,310	13,310	13,310

"Distributable Cash" per share	$ 1.84	$ 1.76	$ 1.60	$ 1.55	$ 1.37
Distributions per share—annual rate	$ 1.40	$ 1.20	$ 1.15	$ 1.10	$ 1.10
Distributions as % of distributable cash	76%	68%	72%	71%	80%


Number of Realtors (end of period)	14,766	13,172	12,149	11,542	10,145

As can be seen above, over 70% of BRE’s revenue in each year has flowed down to the “Distributable Cash” line, available for distribution to shareholders. The company has typically paid out between 70% and 80% of this amount. In 2007, distributable cash per unit was $1.76, and $1.20 (or 68%) was paid out.

Distribution History

BRE has been paying monthly distributions since it went public in August 2003. The initial rate was $1.10 annually, and has been raised several times since, initially in January 2006.

Effective Date Annual Rate

August 2003 $1.10

January 2006 $1.15

January 2007 $1.20

January 2008 $1.25

August 2008 $1.40

Interestingly, the company raised its annual distribution from $1.25 to $1.40 in August, even as the global economy had started to worsen. According to management, they increased the rate at that time because the earning power (and distributable cash) of the company had been increasing and the proportion of distributable cash being paid out was lower than they wanted. Although they acknowledge that the real estate market since then has worsened more than they expected, they say that it will be possible to maintain the current distribution rate for the foreseeable future.

State of Canadian Economy and Real Estate Market

According to the New York Times on December 10^th, “The lack of a mortgage and banking crisis in Canada had shielded the country somewhat from the economic downturn. But a sharp drop in exports to the U.S., particularly of automobiles and auto parts, combined with a collapse in energy and commodity prices has brought it to the point of a recession.” The Bank of Canada just cut interest rates by ¾%, to 1.5%, a 50-year low. And real estate sales in Canada have been dropping sharply in the last couple of months. So, the question is, how bad can it get?

“Worst-Case” Scenario Analysis

For my worst-case analysis, I assumed that the real estate market worsens steadily through 2009, so that by 2010, 25% of the agents in the industry (and in BRE’s network) have quit their jobs, or been forced out, because their productivity is too marginal to justify their existence in the business. I further assume that dollar transactional volume is down 50% from current levels (using TTM at 9/30/08 as a base).

Management states that 67% of the company’s revenues are from “fixed” fees, tied to the number of brokers in the network, and 33% from “variable” fees, tied to transactional volume. This can be slightly misleading, because management includes in their calculation of fixed fees the “Variable Franchise Fees” from the 22% of agents who pay the maximum of $1,300 per year (because their gross commissions exceed $130,000 annually). Their argument is that most of these high-earning agents earn well in excess of $130K, and therefore if their business were to drop somewhat, it wouldn’t impact BRE’s revenues. I don’t fully buy this argument, because the lower-earning agents in this group will see their incomes drop below the $130K threshold in a real-estate downturn, which will reduce BRE’s revenues. After playing around with the numbers, my approach is to assume that fixed fees are 60% of revenues, instead of the 67% assumed by management.

So in the situation where the number of agents is down 25% and transactional volume is down 50%, total revenues would decrease by 35%. Given the cost structure of the company, distributable cash per share will decline by about 40%, to $1.10. Assuming that management wants to maintain the payout ratio at about 70% to 80%, the annual distribution would have to be cut from $1.40 to between $0.80 and $0.90, which would still give a yield of about 10% to 12% based on today’s stock price.

SENSITIVITY ANALYSIS
"WORST-CASE" SCENARIO	2010

Total Revenue	22,484	Assumes 60% fixed; 40% variable

Expenses:
Administration Expenses	(800)	Current run rate
Management Fee	(3,824)	20.7% of Revenues less Admin Exp and Int Exp
Interest Expense	(3,212)	Current run rate
Amortization of Intangible Assets	(17,188)	Current run rate
Total Expenses	(25,024)

Earnings before taxes	(2,540)

"Distributable Cash"--excludes amortization	14,648

Total shares outstanding	13,310

"Distributable Cash" per share	$ 1.10	$ 1.10
Distributions per share--annual rate	$ 0.80	$ 0.90
Distributions as % of distributable cash	73%	82%


BRE Number of Realtors (end of period)	11,078	down 25% from 9/08

Debt structure

BRE had total debt of $51.5 million at the end of September, and cash of $7.7 million, and all of its debt matures in February 2010. Given the strong cash generation ability of the company, and a big parent company, it should not have any problem refinancing this debt when it comes due.

Currency

Given that the US$ has strengthened considerably against the Canadian dollar in recent months, it is possible to imagine some currency gains for US investors over time, though this is not an important part of my investment thesis.

Stock Buyback Program

In early October the company commenced a stock buyback program, under which it is authorized to repurchase up to 5% (approximately 500,000 shares) of its outstanding units in the open market over the next year. As of November 4^th (i.e. over one month), 9,920 shares (0.1% of outstanding shares) were purchased at $8.27 on average. According to the V.P.—Finance, they have acquired another 30,000 shares since then. There are limits to the number of shares they are permitted to buy back daily, but it appears that they plan to actively buy stock while the price is cheap.

Likelihood of Buyout

Given the Canadian tax law changes which make income trusts taxable effective 2011, there have been a spate of buyouts of income trusts, including many that have been written up on VIC. I would venture that there is a reasonable likelihood that BRE is acquired before then, i.e. over the next two years. One obvious buyer is Brookfield Asset Management (BAM), which already owns 25% of BRE. BAM sold 75% of BRE in an IPO in August 2003 at $10 per unit, and would probably be happy to buy back a much larger firm (number of brokers 56% higher than at end-2003; revenues 62% higher than in 2003) at the same price, which would give us a gain of over 30% plus any dividends we collect along the way. (I believe that a buyout by BAM would have to be at a higher price.) Another possible buyer is Berkshire Hathaway’s Home Services of America division, which is the second largest residential broker in the U.S., and is a business Buffett clearly loves (see trev62’s report). (Any interest by Berkshire is pure conjecture on my part, but it is possible to imagine him wanting to acquire the industry leader in Canada with a market share greater than 20% in one very digestible swoop.)

Risks

Canadian real estate market deteriorates much more than I anticipate in my worst-case scenario—I consider this unlikely.
This is a microcap with very limited liquidity.

Catalyst

1. The company’s earning power and distribution rate show modest declines over the next couple of years, until the real estate market and economy improve.
2. Buyout of company.

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			2008	2009
Price:	7.60	EPS
Shares Out. (in M):	0	P/E
Market Cap (in $M):	101	P/FCF
Net Debt (in $M):	0	EBIT	0	0
TEV (in $M):	0	TEV/EBIT