|Shares Out. (in M):||226||P/E||0.0x||0.0x|
|Market Cap (in $M):||1,055||P/FCF||0.0x||0.0x|
|Net Debt (in $M):||74||EBIT||0||0|
Please see charts here: https://www.dropbox.com/s/1gppbg7ax94lt29/Countrywide%20Writeup%2010.20.14.pdf?dl=0
The prevailing pitch, though revolving around Countrywide PLC (CWD.L), is perhaps a more thematic play on the UK real estate agents/lettings market. Under that theme, LSL Property Services (which was recently written up by WeighingMachine on VIC) is also a solid play with many of the same investment qualities as Countrywide. One could establish a mixed position in both names to diversify some of the idiosyncratic risks (such as LSL losing a surveying contract).
Countrywide PLC is the largest real estate agent in the UK, with ~1,350 branches spanning 46 local brands. The Company operates under 5 core functions, all directly tied to the health of the UK housing market (and more directly, to the number of housing transactions. This number was just shy of 1 million in England and Wales in 2013, versus long term averages of ~1.4 million). Countrywide’s core business is real estate brokerage– where the Company’s agents sell homes and collects commissions of ~2% (varies by market). Supplementing this function are the “sell-throughs” – mortgage origination (financing), conveyance, and surveying. In aggregate, these value-add businesses make up 25% of revenues and 31% of pre-corporate EBITDA. The fastest growing segment in recent history been Countrywide’s lettings business (rental) – the division has performed well as it is countercyclical to housing construction/transactions, and has been augmented by a series of acquisitions
We believe Countrywide is an interesting investment due to 1) absolute valuation at ~12x 2014E P/E with housing transactions still ~15% below 30 year averages, 2) capex light business which translates to high FCF, and a business strategy to return ~75% of FCF to shareholders 3) reinvestment opportunities in “rolling up” lettings agencies that have historically been done at ~5-6x EBITDA (20-25% targeted return after 2 years), 4) incremental EBITDA margins across all sectors at 40+%, and 5) structural differences between the UK and US market that make market disruptions less practical.
The risks to the business reside predominantly in the health of the UK markets, unexpected increase in professional indemnity claims, price competition from resurgence of smaller estate agents, and the rise of internet portals like Zoopla and Rightmove. In addition, there are external political risks, evident in the April mortgage review (which puts limits on mortgage loans), and further modifications that may come in other forms.
Countrywide is the largest real estate agency in the UK, with an estimated market share of ~6-7% and ~50% of off-channel mortgage distributions. The Company makes money by helping sellers find a buyer, and on average charges a 2% commission – along with the transaction, Countrywide has ~55% sell through of value-added services such as mortgage financing or conveyance.
While real estate agents have localized specialty (Countrywide and LSL both maintain numerous local brands), Countrywide’s scale allows it to promote all listed homes across its network, and to that end has allowed it to create its own online channel, Propertywide.co.uk. generated ~1/3 of all Countrywide leads last year (the remaining split roughly between Zoopla and Rightmove, the two largest real estate advertising channels in the UK w/ near complete market share). Real estate and London and Premier together accounted for ~50% of revenues and ~40% of pre-corporate EBITDA.
[Chart 2, 3]
In addition to the core business of real estate and lettings brokerage, Countrywide also provides logical value-add (read: “sell through”) services such as surveying, financing and conveyancing. In aggregate, these 3 components of the business (which CWD believes its real estate division provides ~50-60% of the volume) generated ~£34 million of EBITDA, or roughly 28% of the Company’s aggregate pre-corporate EBITDA.
In short summary:
I can’t ascertain the strengths of CWD over competitors beyond 1) its vast array of accolades, 2) its large scale and ability to generate cross-sells, 3) the Company’s market share stability. While competition is bound to increase if the real estate market continues to recover, I think it is likely that the pie expands enough for all industry players to win (at least in the short/medium term). It is important to stress that the large real estate players have all substantially reduced their fixed cost structure following the recession (down 4.5% in 2013, and likely more as the entire IT base is outsourced). Furthermore, CWD is better positioned to weather a new downturn given the rapid growth of its lettings business, which is counter-cyclical and is roughly ~30% of pre-corporate EBITDA.
1) Housing Transaction Volume Recovery
It is readily apparent why the business is highly dependent on real estate transactions – in conjunction with commissions tied to increased business, higher prices of homes also leads to higher absolute commissions (so there is somewhat of a natural hedge between volume and price). Transactions also carry conversion rates of ~58% for financing and ~50% for conveyance. Furthermore, of the 58% that subscribe for financing, 90% also buy life/general insurance. A recovery in volume results in leverage on many aspects of the business (likewise, a weakening of the market will simultaneously hurt all over!).
We will spend a disproportionate amount of time surveying the transaction landscape. At ~13x this years estimated PE with an estimated~1.2 million of transaction volume, we think the shares offer “okay” value if transaction volumes don’t recover, but can provide significant upside if (hopefully when!) they do. We will first provide some “forecasts” to speculate on the potential recovery value, but more importantly delve into historical numbers to attempt to handicap transaction volumes under a “new normal.” On the downside, Countrywide is expensive if transaction volumes permanently fall below 1 million, but capital loss under this scenario seems to be avoidable.
There are a number of factors that suggest the future could be brighter:
The entire sector has sold off recently despite these forecasts on account of commentary on the heated markets (primarily London), as well as curtailments of mortgage lending limits (April MMR). While Foxton tempered the market with reference to a weaker second half, the data through July 2014 doesn’t seem to suggest an overwhelming affect from the mortgage caps:
In addition, we think the focus on short term transaction volumes take away from the longer term picture (focusing on a 2018+ one). Below we depict the 40 year history of transactions since 1971, along with a more selective chart to show recent improvements into 2014.
[Chart 7, 8]
It is true that ownership of homes have skyrocketed from 1951 to 2011, but per the ONS, home ownership in England+Wales in 1981 was 58%. This means that between 1981 and the peak ownership in 2001 at 69%, the ~10% increase in home ownership should not be accounted for as normal transactions (not part of turnover). In those 20 years, there were 31,364 transactions. Assuming 10% of 2011 households were newly initiated, some 2,340 transactions were new transactions. This still leads to ~29 million “turnover” transactions in those 20 years, or on average ~1,450 per year in England and Wales.
Forecasts are all fine and dandy, but let’s double check to see what those numbers are implying (and whether they’re reasonable). Per the ONS, there were 23.4 million households in England+Wales in 2011, of which 64% (or 15 million) were owner occupied, and the remainder were lettings. At the current rate of transaction volumes of ~969,000 a year (2013), and with the conservative assumption that the 8.3 million “lettings” are static, the average turnover of a home is ~15.5 years. Assuming that “lettings” are turned over every 25 years, this implies that of the 969k transactions, 332k are lettings, and the average turnover is ~23.5 years for owner occupied properties.
It’s quite difficult to make assumptions on the stay of owners in their homes, but let’s see what we can find:
Of course, the counterarguments are:
While no one can be heavily certain volumes will tread back to more normalized rates (for the thesis to work, we don’t need an aggressive recovery), I think the current pressure on lower transactions are being affected by some short-termism (fresh recollection of the crises) and manifold concentration on the quarter to quarter volumes on any slight change in mortgage requirements. While prices do seem high (specifically in London and the East, the rest of the UK is still down despite the UK average up 6.5% from peak), I think this is an area that is well in the sights of government officials, whose recent actions (implementations to make non-residents pay UK property profits, multiple mortgage requirement adjustments), , though detrimental for price in the short run, should lead to a healthier medium and long term real estate market.
2) Capex Light Business / Shareholder Focused
In 2013, Countrywide generated pre-NWC operating cash flow of 63 million. A large majority of this was used to finance working capital, particularly provisions of 21 million.
Countrywide’s “ongoing” capex in 2013 was 15.2 million (split, roughly 60/40 on refurbishment of branches and ongoing IT costs. Another 12 million was associated with the 7 year IT transformation, which should dissipate with time). In general, the Company spends has spent ~10 million a year in capex over the last 4 years, though going forward that metric will be higher (up to 20 million through 2015).
Assuming no major changes in NWC or further provisions (steady state, with no transaction volumes growth), Countrywide did 63-15 = ~48 million of FCF in 2013, translating to around ~5% FCF yield on 2013 metrics.
It is hard to estimate what 2014 cash flow might be given the changes in policies and a potential slowdown of the markets, but cash flow pre NWC and provisions for the first half of the year is already 22 million higher (albeit SBC continues to be far higher than anticipated). Assuming that 2H revenues are (like history suggests) ~20% higher, 2H revenues would be ~70-75 million higher than 1H. Assuming employee costs go up commensurately (around 56% of sales), but that rent, advertising, motoring stay relatively similar, then incremental margins might be ~45% over H1, which suggests 2H EBITDA could be ~30-35 million higher. Most of this should then fall through to FCF pre NWC / provisions.
Per CWD’s interim report, in absence of a major acquisition, the Company expects to return 60-70% of reported Group profits in the form of ordinary dividends and supplemental return of cash. CWD also still controls ~4% of Zoopla (worth approximately £40m), which it intends to monetize in the future (as it has with the current special diviend).
3) Capital Deployment Opportunities
The market for real estate brokers is very fragmented. The top 3 players (Countrywide, LSL, and Connells) control ~12.5% of existing branches, the top 10 16.8%, and the numbers drop off rapidly form there. ~80% of branches are owned by small/local players with <10 branches. Lettings are even more fragmented: there were an estimated 2.3 million dwellings for private rental in 2012 in England. Countrywide managed just 52k units in 2013, giving it a market share of just over 2%.
Given the fragmentation, Countrywide has been active in acquisitions. The Company acquired 28 lettings businesses in 2013, and continued the trend with another 16 in the first half of 2014. In conjunction, the Company continues to push its “New Starts” program (opening up lettings branches organically within its existing infrastructure. New Starts EBITDA improved to 1.4 million from -2.7 million over 2012 – margins of ~8% still a ways away from ~28% average margin of lettings segment) and has set aside 20 million to seed a property investment vehicle.
As such, this is a business with 1) very little need for capex, and a commitment to return ~75% of free cash flow to shareholders, 2) significant operating leverage based on existing infrastructure (higher tx volumes require few investments), and 3) opportunity to deploy un-returned FCF at high incremental rates. Below are the acquisitions Countrywide has done over the past couple years, per disclosures in their S-1 and interim reports:
Adjusted for commentary provided throughout the filings and on calls, acquisitions have been done at roughly 5-6x profit (I assume this is an EBIT multiple, but even EBITDA would be very accretive). The CEO further re-iterated, “we expect to make a 20% to 25% return on acquisitions in the second full year of ownership.” While this surely is unsustainable longer term, the opportunities still seem to be quite prevalent.
4) Strong Incremental EBITDA
Countrywide itself publishes what it believes to be adjusted EBITDA contributions (often less investments into the business and/or new business revenues) of ~45-50%. While it is somewhat aggressive to take this at heart, we can look at the incremental EBITDA margins over the last few years (these numbers don’t adjust out investments in personnel that are not yet generating revenues. As such, the ~35% incremental margins is low compared to Company derived estimates in their presentations):
CWD’s own take on incremental EBITDA margins (YTD 2014 vs YTD 2013):
The business shows significant leverage to recovering transaction volumes, as well as increased lettings opportunities. The leverage of the business is understandable – the infrastructure / fixed costs do not change significantly, and management guided to ~50% of employee costs as variable.If volumes recover, fees will likely compress, but the model will work with significantly less incremental EBITDA margin than the Company guides (we model high teens IRR with 35% incremental margins).
Another note of interest is in the numeration report on page 50 of the annual: for long term incentive plans, 2/3 of annual awards are subject to absolute EPS targets. “25% of this part of an award will vest for EPS of 57.6 pence increasing pro rata to 100% vesting for EPS of 70.4 pence for the year ending Decmeber 31, 2016.” Now, there can surely be conflicts by driving long term incentives on EPS, but the Company appears to be expecting some strong bottom line growth (though there’s no top line guidance). Assuming a 12x-14x multiple on 57.6p to 70.4p of earnings, we are looking at a stock worth 691p to 986p based on internal targets.
5) Structural Differences
This is inherently a pretty big and somewhat obfuscated risk. In the UK, two real estate portals – Zoopla and Rightmove – dominate advertising (collectively >80%, and together accounting for ~61% of online property traffic). The businesses essentially charge brokers fees to list their estates/lettings on their respective portals. Both Rightmove and Zoopla have been increasing rates year over year given their large consumer reach (brokers basically “have” to list on them). However, there are probably some limits to the extent of the two Company’s dominance:
It is impossible to deny that Zoopla and Rightmove have dominant mind share, the most sophisticated data, and the largest community (their valuations would suggest as much). There is always risk that the status quo continues and the two continue to pass ARPA increases over its brokers. In the medium term, this risk seems manageable:
With regards to the potential disruption of a UK “Redfin” (which would displace the actual broker itself), the risk of such a startup seems very low. The UK already has the lowest RE commission rates among developed countries (1-2%, compared to 5-6% in the United States). With such a tight spread, it becomes increasingly difficult to justify entering the market (since the potential profit pool is much smaller, and the opportunity for savings for the customer is far more limited).
As an example, Redfin started out in the U.S. in early 2000’s to disrupt the brokerage model. The Company initially charged $3,000 flat fee for selling a home and roughly ~1% to buy a home. Over time, the Company realized that its customers wanted advice, and thus they had to transition to a hybrid services company and hire more real estate agents. As a result, they raised fees to 1.5% to sell a home, and reduced the “kickback” to home buyers. Even so, the old model continues to persist – as of a couple years ago, 42% of people find their homes online but 89% still use a broker, paying average fees of 5.4%.
Furthermore, the interaction of online-only agents, high street agents, and online advertisers is constantly evolving. Online-only agents pitch themselves as doing “everything” a high street broker does, but they also rely exclusively on Rightmove / Zoopla to market their estates. If online-agents displace high street brokers, then Rightmove / Zoopla will end up capturing all the economic rent anyways, so it seems hard to imagine an outcome with a redfin-type player in the U.K.
It is hard to imagine a business like Redfin can be competitive in the U.K., when for ~2% you can get represented by the Country’s largest real estate brokers. However, there surely are sites that are attempting to do so (eMoov, for example), and one must be cautious of this overarching risk.
Results So Far
In the first half of 2014, total income was up 29% YoY and EBITDA was up 70%. While the implementation of April’s MMR may result in a weaker 2nd half than seasonally suggested, historically roughly ~1/3 of EBITDA is generated in the first half. If this pattern holds up, 2014E EBITDA could be in the neighborhood of ~£130 million (Bloomberg estimates are for ~£125 million).
Here are some summary disclosures based on the end of the first half. The optimism might have been subdued somewhat in the last month or so with Foxton’s announcement (though we must remember Foxton is largely London based, which is at the forefront of the bubble mania):
 Based on Bloomberg estimates of 6 analysts as of 9/6/14
 Data for all UK did not start until 1978, but on average, only add `~40k more transactions to England/Wales
 http://old.lettingagenttoday.co.uk/news_features/Acquisition-by-Connells-marks-first-step-in-doubling-size-of-lettings-business - everyone is getting in on this business!
 Total incremental margins for 2013 and YTD 2014 (before non recurring and investments) is around 35-40%. We do not show incremental margins overall because they are not very meaningful (i.e. mix shift effect clouds individual segments, esp. if some fell while others increased)
 Zoopla and Rightmove are akin to Trulia and Zillow (aggregator and advertiser). Redfin runs a different model
 Jeffries Zoopla initiating report, August 2014
 Savills, Knight Frank, Strutt & Parker, Chesterton Humberts, Douglas & Gordon, and Glentree Estates
 When redfin represents the buyer, it accepts the standard 3% on the selling price of the house, but initially gave 2% back to the buyer (so collecting only a 1% fee)
 As of 9/6/2014. CWD states that 1H accounts for ~45% of revenues and 2H for roughly 55%. If this holds true,
 Page 4 of transcript
|Subject||RE: Incremental EBITDA margins|
|Entry||10/25/2014 04:53 PM|
Thanks for the questions. I apologize that the model outputs are somewhat misleading. I modeled in acquired EBITDA but did not model in associated revenues form acquisitions (since I would be making an assumption to back out acquired revenue, which I didn't think was necessary), hence why "incremental" margins are deceptively high. I am modelling only 35%, down to 30% organic incremental EBITDA margins on any organic revenue growth (the ~3% topline).
Taking out the acquired EBITDA, i am modelling ~19.5% EBITDA margins in 2018. I talked to Jim (CFO) about the implied EBITDA margins based on the proxy EPS targets (I thought it would imply margins over 20%), and he confirmed that margins would indeed be well over 20% given the new cost structure if tx volumes are at 1.4 million. Most of it is just the leverage of the infrastructure (half of employee costs are variable), as well as the continued expansion of the lettings business, which carries higher EBITDA margins (the model works differently from real estate)
Be happy to share my model if you'd like to take it offline-
|Entry||10/27/2014 11:48 AM|
Thank you for the write-up, great job. Have your thoughts changed at all due to the Foxton Q3 results? I know you brought up the slowdown in the write-up yet it seems the incremental London warning spooked the market. With that in mind, what are your thoughts on the positioning of LSL vis-a-vis CWD, which is cheaper on an absolute basis (~11x LTM EPS) along with materially lower exposure to London?
|Entry||10/30/2014 08:04 PM|
Lettings is a machine. Re: MSLM28's question of LSL vs. CWD's London exposure, I would note that they are not materially different. Recall LSL bought Marsh & Parson's in 2011 to develop its London business and it accounts for roughly the same % of OP (20% or so from memory). I'd also note that while CWD & LSL break out their lettings businesses separately, CWD's London & Premier segment includes London lettings and is more stable than one would expect from transactions.